## _022013a - EXECUTIVE SUMMARY

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### Characteristics of Asia and Pacific small states
- Unique challenges: small populations, geographical isolation and dispersion, narrow export and production bases, lack of economies of scale, limited access to international capital markets, exposure to shocks (including climate change), and heavy reliance on aid.
- Higher fixed government costs in providing public services relative to other states; island remoteness and dispersion compound costs.
- Low access to credit by the private sector impedes inclusive growth; capacity constraints limit policy implementation.
- Institutional features:
  - Five out of 13 countries do not have a central bank.
  - The Asia and Pacific developing (APD) small states group includes: Bhutan, Fiji, Kiribati, Maldives, Marshall Islands, Micronesia, Palau, Samoa, Solomon Islands, Timor-Leste, Tonga, Tuvalu, and Vanuatu.
  - Micro states (2011 populations below 200,000): Kiribati, Marshall Islands, Micronesia, Palau, Samoa, Tonga, and Tuvalu.
- Remoteness and dispersion:
  - PICs occupy 15 percent of the globe’s surface and are highly dispersed.
  - Two PICs are the smallest IMF members in population terms—Tuvalu and Palau.
  - PICs’ average population is half the average population of other small states outside the Pacific region.
- Narrow and heterogeneous export/production bases (principal sectors by country):
  - Bhutan: Hydroelectricity; Minerals.
  - Maldives: Tourism; Fish.
  - Timor-Leste: Oil; Coffee.
  - Fiji: Tourism; Sugar.
  - Kiribati: Fish; Copra.
  - Marshall Islands: Fish; Copra.
  - Micronesia: Fish; Copra.
  - Palau: Tourism; Fish.
  - Samoa: Tourism; Copra.
  - Solomon Islands: Logs; Gold.
  - Tonga: Agriculture (squash); Tourism.
  - Tuvalu: Fish; Copra.
  - Vanuatu: Tourism; Copra.
- Public spending: current government spending as a share of GDP is generally higher in the micro states than in all other groups.
- Trade and connectivity: PICs appear less open than comparators though openness has increased recently; poor connectivity and high transport costs hinder trade integration and competitiveness.
- Financial sector characteristics:
  - Financial depth generally below that of other small states.
  - Communal land tenure constrains credit growth and private sector development in several Pacific Islands.
  - Interest rate spreads are very high in the Pacific Islands.
  - Commercial banks in the Pacific Islands—mainly foreign banks—are well capitalized and highly profitable, with high non-interest income largely from foreign exchange activities and fees.

### Managing shocks, vulnerability, and volatility
- Exposure to shocks: high exposure to natural disasters, terms-of-trade shocks, and other external and domestic shocks; generally more vulnerable than many comparators.
- Fiscal policy: fiscal policies have at times been pro-cyclical given large development needs.
- Volatility drivers and patterns:
  - Micro states experience more macroeconomic volatility than the rest of the Asia-Pacific small states.
  - Key volatility drivers: GDP growth swings, terms of trade, aid flows, and current account balance movements.
- Fiscal and external positions:
  - Current account positions are sensitive to grants and export performance.
  - Public debt levels and revenue volatility are important determinants of fiscal sustainability.

### Growth performance and determinants
- Growth outcomes:
  - Growth rates have remained quite low despite some resilience relative to comparators during the recent business cycle.
- Factors supporting relative resilience:
  - Sound policies in some countries.
  - Strong linkages with resilient economies in the region.
  - Some small states have built policy buffers.
- Constraints on growth potential:
  - Narrow export bases and limited scope for diversification (exceptions include Fiji and Samoa).
  - Remoteness, high transport costs, weak connectivity, and limited financial depth.
- Notable developments:
  - Niche or eco-tourism developing in Kiribati, Marshall Islands, and Micronesia.
  - Joint ventures for marine processing emerging to move up the value-added chain.
- Econometric findings:
  - PICs suffer a disadvantage in per capita GDP growth of about 2 percentage points compared with an average small state.
  - Small states have grown 1¼ percentage points less than big states (Model 1); after controls PICs have grown by 3 percentage points less than non-small states (Model 2).
  - Including remoteness (distance to closest continent) makes PIC and small-state dummies insignificant (Model 5); distance coefficient negative and significant.
  - Other negative contributors: higher fixed government costs, capacity constraints, less openness, and higher GDP volatility.

### Financial development, inclusion, and banking income structure (High‑fidelity figures)
- Regression evidence: negative relationship between inequality (Gini coefficient) and the share of private credit as a percent of GDP (simple regression).
- Recent financial inclusion developments:
  - Increasing use of mobile phone networks for basic financial services in Fiji, Samoa, Solomon Islands, and Tonga.
  - Decreasing cost of sending remittances to the Pacific by Australian banks.
- Interest and non-interest income of commercial banks in Small Pacific Island Countries, 2011 (percent of total assets):
  - Fiji: Net interest income 3.6; Non-interest income 3.0
  - Marshall Islands: Net interest income 12.9; Non-interest income 1.3
  - Palau: Net interest income 15.5; Non-interest income 1.2
  - Samoa: Net interest income 6.0; Non-interest income 4.0
  - Solomon Islands: Net interest income 5.2; Non-interest income 6.2
  - Tonga: Net interest income 5.1; Non-interest income 4.8
  - Vanuatu: Net interest income 4.0; Non-interest income 3.2
  - Memorandum items:
    - Australia: Net interest income 1.8; Non-interest income 0.9
    - Antigua and Barbuda: Net interest income 4.6; Non-interest income 4.3
    - Bahamas: Net interest income 5.5; Non-interest income 0.3
    - Grenada: Net interest income 4.4; Non-interest income 4.2
    - St. Kitts and Nevis: Net interest income 1.9; Non-interest income 5.9
    - St. Lucia: Net interest income 3.8; Non-interest income 4.7
    - St. Vincent and the Grenadines: Net interest income 3.9; Non-interest income 4.7
    - Suriname: Net interest income 1.4; Non-interest income 0.6
    - Cape Verde: Net interest income 3.7; Non-interest income 1.1
    - Mauritius: Net interest income 2.0; Non-interest income 1.0
    - Seychelles: Net interest income 3.1; Non-interest income 2.9
    - PICs (average): Net interest income 7.5; Non-interest income 3.4
    - Small Caribbean states (average): Net interest income 3.6; Non-interest income 3.5
    - Small African states (average): Net interest income 2.9; Non-interest income 1.7

### Market access, monetary regimes, and capacity constraints
- International market access: very limited for Pacific Islands due to capacity and structural impediments; market access to private capital flows is almost nonexistent, excluding Fiji and Maldives.
- Business environment: Doing Business indicators show procedures for starting and closing a business are more expensive in the small Pacific islands than in other Asia and Pacific small states and than in Caribbean island countries.
- Central bank and currency arrangements:
  - Five out of 13 countries do not have a central bank: Kiribati, Marshall Islands, Micronesia, Palau, and Tuvalu.
  - The Australian dollar circulates as legal tender in Kiribati and Tuvalu; the U.S. dollar in Marshall Islands, Micronesia, and Palau.
  - Widespread dollarization or fixed/managed exchange rate regimes reflect fixed costs of independent monetary policy and weak monetary transmission.
- Capacity and human development:
  - Capacity constraints in public services are larger in PICs relative to comparators and linked to small size.
  - School enrollment: secondary school enrollment, percent of population between 12-17 years old, 1990-2010 average: APD small states average = 3.3? — source shows relative comparisons in Figure 14.
  - Human development: of the 12 countries with the lowest rank on the human development index in the Asia and Pacific region, 6 are small states and 3 are micro states.

### Shocks, aid, and natural disaster exposure (Key figures preserved)
- Main spillover channels from a global downturn: terms of trade, remittances, tourist flows, and financial channels.
- Import composition: food and fuel constitute about 50 percent of total imports for PICs, increasing vulnerability to global commodity price shocks.
- Remittances and tourism: changes affect Samoa, Tonga, Tuvalu (remittances) and Maldives, Palau, Vanuatu, Samoa, Fiji (tourism) materially.
- Offshore trust funds: a fall in advanced-economy stock prices affects PICs with large trust funds invested offshore (Kiribati, Marshall Islands, Micronesia, Palau, Tuvalu), as in 2008–09.
- Official development aid by OECD donors (In percent of total aid, 2005-11):
  - Australia 41%; United States 22%; Japan 17%; New Zealand 7%; EU 12%; Others 1%.
- Aid concentration:
  - Aid from the United States represents over 65 percent of total aid in Palau and 90 percent of total aid in Marshall Islands and Micronesia.
  - Many PICs rely on “Compact grants” (U.S. Compact of Free Association) for budgetary and balance of payments needs; these grants are scheduled to expire in the 2023/24 fiscal year.
- External grants, 2011 (In percent of GDP):
  - PICs average = 24.1; APD small states average = 22.5; Small states average = 9.5.
- Natural disasters and climate change:
  - 2012 World Bank report: of the 20 countries with the highest average annual disaster losses measured by GDP, 8 are PICs: Vanuatu, Niue, Tonga, Micronesia, Solomon Islands, Fiji, Marshall Islands, and the Cook Islands.
  - Several small island countries are low-lying coral islands (Kiribati, Maldives, Marshall Islands, Tuvalu) with populations and infrastructure concentrated along the coast, making them highly vulnerable to sea-level rise and coastal erosion.
  - The costs of climate change (including fiscal costs) remain largely unestimated for these small states.
- Frequency of shocks: political, terms-of-trade, and natural disaster shocks are more frequent in the small Pacific Islands relative to other low-income small states.

### Vulnerabilities: trade deficits, aid/remittance reliance, and debt
- Structural trade deficits and narrow domestic markets lead to reliance on aid and remittances to finance deficits; most Asia-Pacific small states are net importers of energy and food and import capital goods.
- Debt trends and risk classifications (as of February 2013, based on latest Article IV staff reports):
  - Four Asia-Pacific small states at high risk of debt distress: Kiribati, Maldives, Tonga, and Tuvalu (low-income countries debt sustainability analysis).
  - Three at moderate risk of debt distress: Bhutan, Samoa, and Solomon Islands.
  - Two at low risk of debt distress: Fiji and Vanuatu.
- ODA and debt dynamics: ODA flows kept debt in check until recent years; debt increased since the 2008–09 crisis due to countercyclical fiscal support and new borrowing, narrowing fiscal space.

### Volatility: output, terms of trade, aid, and fiscal revenue
- GDP per capita volatility (1990–2010): higher in Asia and Pacific small states, especially micro states (all PICs); Tuvalu experienced the highest variability among PICs; Timor-Leste and Maldives also faced high GDP volatility.
- Association: higher output volatility associated with lower economic growth during 1990–2010 and lower quality of governance (after controls).
- Terms of trade and aid volatility: during 1990–2010, terms of trade and aid flows were more volatile than in other small states; aid volatility increased with a drop in European donors and rise of Australia as a large aid provider.
- Revenue volatility:
  - Revenue volatility is higher in Asia and Pacific small states—especially micro states—relative to other small states.
  - Main source in micro states: non-tax revenues—particularly fishing license fees, which represent about 40 percent of revenues in micro states.
  - Revenue volatility encourages pro-cyclical fiscal policy; fiscal policy appears to have been pro-cyclical in many Asia and Pacific small states in recent years.
- Institutional responses:
  - Only 5 out of 13 countries have adopted a multi-year budget framework.
  - Only one country, Timor-Leste, has a fiscal rule and a stabilization fund to manage fiscal revenue volatility and ensure intergenerational equity from natural resource earnings.

### Policy implications and recommendations
- Rebuild policy buffers given high vulnerability to external shocks.
- Improve composition of public spending to foster inclusive growth, emphasizing education, health, and infrastructure.
- Properly exploit and manage enormous untapped marine resources.
- Continue pursuing regional solutions, mainly in fisheries, information technology, and aviation safety.
- Further integration with the Asia and Pacific region to help raise growth potential.
- Address structural constraints to private sector credit access (including land tenure issues) to promote inclusive growth.
- Consider fiscal frameworks to reduce pro-cyclicality.
- Financial sector and inclusion measures:
  - Increase competition in the banking sector and develop non-bank institutions (finance companies, foreign exchange dealers, micro-credit institutions).
  - Promote financial-inclusion initiatives such as lowering the cost of remittances and mobile phone banking.
- Regional approaches:
  - Pursue regional solutions to mitigate small size and dispersion, increase economies of scale, align regulations and laws, lower transaction costs, promote exchange of knowledge and best practices, and explore regional natural disaster risk insurance.
  - Continue progress in fisheries (e.g., Nauru Agreement) to strengthen bargaining power of license-issuing countries and control illegal fishing.
  - Address major barriers to labor and investment; seasonal employment schemes (New Zealand since 2006, followed by Australia) have generated income opportunities and enhanced skills.

### IMF engagement, surveillance, and coordination
- Increased IMF engagement over the last three years via technical assistance and program cases.
- Two-thirds of the Asia and Pacific small states are currently on a 24-month Article IV consultation cycle.
- Surveillance recommendation: given vulnerability to shocks, moving to a 12-month Article IV cycle could achieve further monitoring, as is the case for most small states in other regions.
- Institutional presence and cooperation:
  - IMF established in September 2010 a regional resident representative office for Pacific Island countries based in Suva (Fiji) and a Pacific Islands Unit at HQ.
  - In October 2011, an interdepartmental working group—the Small Island Club—was launched to share analytical and policy work on small island states.
  - The Fund has increased synergies with development partners: World Bank and Asian Development Bank colleagues regularly join IMF Article IV missions; closer engagement with AusAID, the New Zealand aid programme, and the EU.
  - The Fund participates regularly in regional meetings (Forum Economic Ministers’ Meeting; South Pacific Central Bank Governors Meeting).
- Programs and technical assistance examples:
  - Three-year Extended Credit Facility (ECF) with Solomon Islands began in early December 2012 following a Stand-By Credit Facility (SCF).
  - Rapid Access Component of the Exogenous Shocks Facility approved for Samoa after the 2009 tsunami.
  - Stand-By Arrangement and Exogenous Shocks Facility approved for Maldives in late 2009.
  - Pacific Financial Technical Assistance Centre (PFTAC) has provided technical assistance and training for almost twenty years; PFTAC expanded to seven advisors and a coordinator since mid-2011.
  - Since December 2012, the IMF Statistics Department provided technical assistance on external sector statistics funded by Japan for selected small states.
- Outreach and events:
  - Fund co-organized a Pacific seminar in Tokyo during the 2012 Annual meetings.
  - The first high-level regional conference on the Pacific Islands was organized in Samoa in March 2012.
  - The next IMF regional conference on the Pacific Islands is scheduled for late 2013 and will focus on policies aimed at boosting potential growth.
- Coordination recommendation: further coordination with development partners could be pursued to avoid duplication of effort and prevent excessive burden on authorities.

---

### Box 1. Special Challenges Facing Pacific Islands Micro States (summary)
- Key vulnerabilities:
  - More volatility in GDP growth, revenue, aid, terms of trade, and current accounts relative to other small states.
  - Climate change: rising sea level major threat for Kiribati, Marshall Islands, and Tuvalu; development spending sometimes redirected to sea walls; climate mitigation aid expected to crowd out other project-financing aid unless overall aid expands.
  - High aid dependency: expiration of “Compact grants” in fiscal year 2023/24 would create fiscal and external difficulties for Marshall Islands, Micronesia, and Palau absent reforms.
  - Fragility: Kiribati, Marshall Islands, and Micronesia are classified as fragile by the World Bank; other fragile Asia and Pacific small states include Solomon Islands and Timor-Leste.
- Growth and income indicators:
  - Since 1990, real GDP per capita (PPP) in PICs increased less than 25 percent, compared with 45 percent in the ECCU and more than 30 percent in small states; emerging Asia GDP increased by about 120 percent over the same period.
  - During 1990–2010, per capita income (PPP) in the Pacific grew by 77 percent, compared with 130 percent in the ECCU and less than 85 percent in the small states; emerging Asia grew by over 250 percent.
  - As of 2011, the average GNI per capita for the PICs was one third the average income of the Caribbean countries.
  - Tuvalu: GNI exceeds GDP by 60 percent because of sizable government investment income from its sovereign trust fund (established in 1987); the inflation component of earnings is about two-third of total earnings, or about 10 percent of GNI, which is the amount needed every year to maintain the value of the fund constant in real terms.
  - Marshall Islands and Micronesia are bound by a similar bilateral agreement with the United States governing trust fund management until 2023/24.
  - Over the last 20 years, PICs’ annual GDP growth averaged just 2 percent—less than Asian low-income countries (6 percent), the ECCU (4 percent), and small states (4½ percent).
- Policy priorities for micro states:
  - Rebuild policy buffers and strengthen domestic revenue mobilization; streamline and simplify tax and customs regimes with technical assistance.
  - Improve public spending composition toward education, health, and infrastructure to foster inclusive growth and crowd-in private investment and FDI.
  - Implement growth-oriented structural reforms to enhance business environment and properly exploit marine resources.
  - Strengthen institutions and public finance management; introduce multi-year budget frameworks and simple fiscal anchors; balance rebuilding buffers with priority spending while accounting for capacity constraints.
  - Financial sector: increase banking competition, develop non-bank institutions, lower remittance costs, and expand mobile banking.
  - Regional solutions: pursue regional approaches for economies of scale, aligned regulations, knowledge sharing, and regional disaster risk insurance; continue fisheries cooperation (e.g., Nauru Agreement) and seasonal employment schemes.
- IMF role:
  - Surveillance, programs, technical assistance, cooperation, and outreach to support PICs.
  - Examples of program support and technical assistance are listed above.
  - Institutional presence and cross-departmental initiatives support ongoing engagement.

*Source: _022013a - Executive Summary; Box 1; sections 8 and 41 (International Monetary Fund).*

### EXECUTIVE SUMMARY

### _022013a - EXECUTIVE SUMMARY

### Characteristics of Asia and Pacific small states
- The group faces unique challenges: small populations, geographical isolation and dispersion, narrow export and production bases, lack of economies of scale, limited access to international capital markets, exposure to shocks (including climate change), and heavy reliance on aid.
- Higher fixed government costs in providing public services relative to other states, compounded in island states by remoteness and dispersion.
- Low access to credit by the private sector impedes inclusive growth; capacity constraints limit policy implementation.
- Five out of 13 countries do not have a central bank.
- Within the group, the micro states are subject to more vulnerability and macroeconomic volatility than the rest of the Asia-Pacific small states.
- The Asia and Pacific developing (APD) small states group includes: Bhutan, Fiji, Kiribati, Maldives, Marshall Islands, Micronesia, Palau, Samoa, Solomon Islands, Timor-Leste, Tonga, Tuvalu, and Vanuatu.
- Micro states (2011 populations below 200,000) include: Kiribati, Marshall Islands, Micronesia, Palau, Samoa, Tonga, and Tuvalu.
- Remoteness and dispersion indicators and country examples:
  - PICs occupy 15 percent of the globe’s surface and are highly dispersed.
  - Two PICs are the smallest IMF members in population terms—Tuvalu and Palau.
  - PICs’ average population is half the average population of other small states outside the Pacific region.
- Export and production bases are narrow and heterogeneous:
  - Bhutan: Hydroelectricity; Minerals.
  - Maldives: Tourism; Fish.
  - Timor-Leste: Oil; Coffee.
  - Fiji: Tourism; Sugar.
  - Kiribati: Fish; Copra.
  - Marshall Islands: Fish; Copra.
  - Micronesia: Fish; Copra.
  - Palau: Tourism; Fish.
  - Samoa: Tourism; Copra.
  - Solomon Islands: Logs; Gold.
  - Tonga: Agriculture (squash); Tourism.
  - Tuvalu: Fish; Copra.
  - Vanuatu: Tourism; Copra.
- Public spending patterns:
  - Current government spending as a share of GDP is generally higher in the micro states than in all other groups.
- Trade and connectivity:
  - PICs appear less open than comparators, though openness has increased recently.
  - Poor connectivity and high transport costs hinder trade integration and competitiveness.
- Financial sector characteristics:
  - Financial depth is generally below that of other small states.
  - Land tenure (communal land) is a constraint on credit growth and private sector development in several Pacific Islands.
  - Interest rate spreads are very high in the Pacific Islands.
  - Commercial banks in the Pacific Islands—mainly foreign banks—are well capitalized and highly profitable, with continued high non-interest income largely from foreign exchange activities and from fees and charges.

### Managing shocks, vulnerability, and volatility
- These countries are particularly exposed to shocks, including natural disasters and terms-of-trade shocks, and are generally more vulnerable than many comparators.
- Fiscal policies have, at times, been pro-cyclical given large development needs.
- Volatility:
  - Micro states experience more macroeconomic volatility than the rest of the Asia-Pacific small states.
  - Key volatility drivers include GDP growth swings, terms of trade, aid flows, and current account balance movements.
- Fiscal and external positions:
  - Current account positions are sensitive to grants and export performance.
  - Public debt levels and revenue volatility are important determinants of fiscal sustainability in the group.

### Growth performance and determinants
- Growth outcomes have been modest:
  - Growth rates have remained quite low despite some resilience relative to comparators during the recent business cycle.
- Factors supporting relative resilience:
  - Sound policies in some countries.
  - Strong linkages with resilient economies in the region.
  - Some small states have made progress in building policy buffers.
- Constraints on growth potential:
  - Narrow export bases and limited scope for economic diversification (with exceptions such as Fiji and Samoa).
  - Remoteness, high transport costs, weak connectivity, and limited financial depth.
- Notable developments:
  - Niche or eco-tourism is gradually developing in Kiribati, Marshall Islands, and Micronesia.
  - Joint ventures for marine processing are emerging as ways to move up the value-added chain.

### Policy implications and recommendations
- Rebuild policy buffers given high vulnerability to external shocks.
- Improve composition of public spending to foster inclusive growth, with emphasis on education, health, and infrastructure.
- Properly exploit and manage enormous untapped marine resources.
- Continue pursuing regional solutions, mainly in fisheries, information technology, and aviation safety.
- Further integration with the Asia and Pacific region to help raise growth potential.
- Address structural constraints to private sector credit access (including land tenure issues) to promote inclusive growth.
- Consider fiscal frameworks to reduce pro-cyclicality.

### IMF engagement and surveillance recommendations
- IMF engagement in the Asia and Pacific small states has increased over the last three years, including through technical assistance and program cases.
- Two-thirds of the Asia and Pacific small states are currently on a 24-month Article IV consultation cycle.
- Given their vulnerability to shocks, further monitoring could be achieved by moving them to a 12-month cycle, as is the case for most of the small states in other regions.

*February 20, 2013 — Prepared by a team led by Patrizia Tumbarello, and comprising Ezequiel Cabezon, and Yiqun Wu (all APD, Pacific Islands Unit). International Monetary Fund.*

### 8. Low access to credit by the private sector is an impediment to inclusive growth

### 8. Low access to credit by the private sector is an impediment to inclusive growth

### Financial development, inclusion, and bank income structure
- A simple regression suggests a negative relationship between inequality (proxied by the Gini coefficient) and the share of private credit as a percent of GDP.
- Recent positive developments supporting financial inclusion:
  - Increasing use of mobile phone networks for basic financial services in Fiji, Samoa, Solomon Islands, and Tonga.
  - Decreasing cost of sending remittances to the Pacific by Australian banks.
- Interest and non-interest income of commercial banks in Small Pacific Island Countries, 2011 (percent of total assets):
  - Fiji: Net interest income 3.6; Non-interest income 3.0
  - Marshall Islands: Net interest income 12.9; Non-interest income 1.3
  - Palau: Net interest income 15.5; Non-interest income 1.2
  - Samoa: Net interest income 6.0; Non-interest income 4.0
  - Solomon Islands: Net interest income 5.2; Non-interest income 6.2
  - Tonga: Net interest income 5.1; Non-interest income 4.8
  - Vanuatu: Net interest income 4.0; Non-interest income 3.2
  - Memorandum items:
    - Australia: Net interest income 1.8; Non-interest income 0.9
    - Antigua and Barbuda: Net interest income 4.6; Non-interest income 4.3
    - Bahamas: Net interest income 5.5; Non-interest income 0.3
    - Grenada: Net interest income 4.4; Non-interest income 4.2
    - St. Kitts and Nevis: Net interest income 1.9; Non-interest income 5.9
    - St. Lucia: Net interest income 3.8; Non-interest income 4.7
    - St. Vincent and the Grenadines: Net interest income 3.9; Non-interest income 4.7
    - Suriname: Net interest income 1.4; Non-interest income 0.6
    - Cape Verde: Net interest income 3.7; Non-interest income 1.1
    - Mauritius: Net interest income 2.0; Non-interest income 1.0
    - Seychelles: Net interest income 3.1; Non-interest income 2.9
    - PICs (average): Net interest income 7.5; Non-interest income 3.4
    - Small Caribbean states (average): Net interest income 3.6; Non-interest income 3.5
    - Small African states (average): Net interest income 2.9; Non-interest income 1.7

### Market access, business environment, and policy tools
- International market access is very limited for Pacific Islands because of capacity and structural impediments, including legal and administrative frameworks; market access to private capital flows is almost nonexistent, excluding Fiji and Maldives.
- Doing Business indicators: procedures for starting and closing a business are more expensive in the small Pacific islands than in other Asia and Pacific small states and than in Caribbean island countries, impeding private sector development.
- Central bank and monetary regime characteristics:
  - Five out of 13 countries do not have a central bank: Kiribati, Marshall Islands, Micronesia, Palau, and Tuvalu.
  - The Australian dollar circulates as legal tender in Kiribati and Tuvalu; the U.S. dollar in Marshall Islands, Micronesia, and Palau.
  - Widespread use of dollarization or fixed/managed exchange rate regimes reflects fixed costs of operating an independent monetary policy and weak monetary transmission (shallow money markets, absence of credit bureaus, small market size).

### Capacity constraints and human development
- Capacity constraints in public services are larger in the Pacific Island Countries (PICs) relative to comparators and are associated with small size; these constraints help explain underperformance on public financial management reforms.
- School enrollment is lower than in other small states (secondary school enrollment, percent of population between 12-17 years old, 1990-2010 average: APD small states average = 3.3? — source shows relative comparisons in Figure 14).
- Human development: of the 12 countries with the lowest rank on the human development index in the Asia and Pacific region, 6 are small states and 3 are micro states.

### Shocks: exposure and transmission channels
- Small states in the Asia and Pacific region are heavily exposed to external, weather/environmental, and domestic (political) shocks.
- Main channels of spillover from a global downturn:
  - Terms of trade, remittances, tourist flows, and financial channels.
  - All PICs remain especially vulnerable to global commodity price shocks—particularly for food and fuel, given their large share in total imports (about 50 percent).
  - Changes in remittances (important in Samoa, Tonga, Tuvalu, and to a lesser extent Fiji) and tourism receipts (important in Maldives, Palau, Vanuatu, Samoa, and Fiji) are key contagion channels.
  - A fall in advanced-economy stock prices affects PICs with large trust funds invested offshore (Kiribati, Marshall Islands, Micronesia, Palau, and Tuvalu), as in 2008–09.
- Aid patterns and dependency:
  - Official development aid by OECD donors (In percent of total aid, 2005-11): Australia 41%; United States 22%; Japan 17%; New Zealand 7%; EU 12%; Others 1%.
  - Aid from the United States represents over 65 percent of total aid in Palau and 90 percent of total aid in Marshall Islands and Micronesia.
  - Many PICs rely on “Compact grants” (U.S. Compact of Free Association) for budgetary and balance of payments needs; these grants are scheduled to expire in the 2023/24 fiscal year.
  - External grants, 2011 (In percent of GDP): PICs average = 24.1; APD small states average = 22.5; Small states average = 9.5.
- Natural disasters and climate change:
  - According to a 2012 World Bank report, of the 20 countries with the highest average annual disaster losses measured by GDP, 8 are PICs: Vanuatu, Niue, Tonga, Micronesia, Solomon Islands, Fiji, Marshall Islands, and the Cook Islands.
  - Several small island countries are low-lying coral islands (Kiribati, Maldives, Marshall Islands, Tuvalu) with populations and infrastructure concentrated along the coast, making them highly vulnerable to sea-level rise and coastal erosion.
  - The costs of climate change (including fiscal costs) remain largely unestimated for these small states.
- Frequency of shocks:
  - Event analysis shows political, terms-of-trade, and natural disaster shocks are more frequent in the small Pacific Islands relative to other low-income small states.

### Vulnerabilities: trade deficits, aid/remittance reliance, and debt
- Structural trade deficits and narrow domestic markets lead to reliance on aid and remittances to finance deficits; most Asia-Pacific small states are net importers of energy and food and import capital goods.
- Trade balance of goods and services (In percent of GDP, 2005-11 average) shows substantial imports relative to exports for many small states.
- Debt trends:
  - ODA flows kept debt in check until recent years, but debt increased since the 2008–09 crisis due to countercyclical fiscal support and new borrowing.
  - Fiscal space is limited for Asia and Pacific small states with high public debt, narrowing scope for countercyclical policies.
  - As of February 2013 (based on latest Article IV staff reports):
    - Four Asia-Pacific small states were at high risk of debt distress: Kiribati, Maldives, Tonga, and Tuvalu (low-income countries debt sustainability analysis).
    - Three were at moderate risk of debt distress: Bhutan, Samoa, and Solomon Islands.
    - Two were at low risk of debt distress: Fiji and Vanuatu.

### Volatility: output, terms of trade, aid, and fiscal revenue
- Higher volatility in Asia and Pacific small states relative to other small states across multiple dimensions:
  - GDP per capita volatility (1990–2010) was higher, especially in micro states (all PICs); Tuvalu experienced the highest variability among PICs; Timor-Leste and Maldives also faced high GDP volatility.
  - Higher output volatility was associated with lower economic growth during 1990–2010 and with lower quality of governance (after controlling for other variables).
- Terms of trade, aid, and current account volatility:
  - During 1990–2010, terms of trade and aid flows were more volatile than in other small states; aid volatility increased with a drop in assistance from traditional European donors and the rise of Australia as a large aid provider.
  - Greater aid volatility in micro states may reflect that aid often finances specific one-off projects.
  - Volatility of terms of trade and aid contributed to greater current account volatility.
- Revenue and fiscal volatility:
  - Revenue volatility is higher in Asia and Pacific small states—especially micro states—relative to other small states.
  - The main source of volatility in micro states is non-tax revenues—particularly fishing license fees, which represent about 40 percent of revenues in micro states.
  - Revenue volatility encourages pro-cyclical fiscal policy (expansionary in upturns, contractionary in downturns); fiscal policy appears to have been pro-cyclical in many Asia and Pacific small states in recent years.
  - Institutional responses:
    - Only 5 out of 13 countries have adopted a multi-year budget framework to smooth expenditure over the medium term.
    - Only one country, Timor-Leste, has a fiscal rule and a stabilization fund to manage fiscal revenue volatility and ensure intergenerational equity from natural resource earnings.

*Source: _022013a - 8. Low access to credit by the private sector is an impediment to inclusive growth*

### Box 1. Special Challenges Facing Pacific Islands Micro States

### Box 1. Special Challenges Facing Pacific Islands Micro States

### Key vulnerabilities and challenges
- More volatility: Micro states face more volatility in GDP growth, revenue, aid, terms of trade, and current accounts relative to the rest of the Asia-Pacific small states and other small states outside the region.
- Climate change: Rising sea level is a large threat for Kiribati, Marshall Islands, and Tuvalu. The costs of climate change cannot be internalized by individual countries. Development spending is sometimes redirected to building sea walls. Aid for climate-change mitigation is expected to come at the expense of other project-financing aid, unless the aid envelope expands substantially—which does not appear likely.
- High aid dependency: The micro states depend heavily on aid to finance their large external and internal imbalances, and their development needs. The expiration of the “Compact grants” in fiscal year 2023/24 would create both fiscal and external difficulties for Marshall Islands, Micronesia, and Palau if they fail to implement reforms to achieve self-sufficiency.
- Fragility: Kiribati, Marshall Islands, and Micronesia are classified as fragile states by the World Bank. The other fragile Asia and Pacific small states are Solomon Islands and Timor-Leste.

### Growth performance and income indicators
- Since 1990, real GDP per capita (in PPP terms) in the PICs has increased less than 25 percent, compared with 45 percent in the Eastern Caribbean Currency Union (ECCU) and more than 30 percent in small states. PICs have not benefited from growth in emerging Asia—where GDP has increased by about 120 percent over the same period.
- During 1990–2010, per capita income (in PPP terms) in the Pacific grew by 77 percent, compared with 130 percent in the ECCU and less than 85 percent in the small states. Per capita income in emerging Asia had grown by over 250 percent over the same period.
- As of 2011, the average GNI per capita for the PICs was one third the average income of the Caribbean countries.
- Tuvalu: GNI exceeds GDP by 60 percent because of sizable government investment income from its sovereign trust fund whose assets are invested abroad. The multilateral agreement governing the fund stipulates that the real value of the Trust Fund, indexed to Australian inflation, be maintained, which limits the use of earnings for budget support. The inflation component of earnings is about two-third of total earnings, or about 10 percent of GNI, which is the amount needed every year to maintain the value of the fund constant in real terms. The trust fund was established in 1987.
- Marshall Islands and Micronesia are bound by a similar bilateral agreement with the United States governing the trust fund management until 2023/24.
- Growth trajectory: Over the last 20 years, PICs’ annual GDP growth has averaged just 2 percent—much lower than the Asian low-income countries (6 percent), the ECCU countries (4 percent), and the small states (4½ percent). Because of demographics, the underperformance in per capita terms is more striking.
- Recent cycle: PICs have done slightly better than comparators during the recent business cycle, but growth rates remain quite low, especially among the net commodity importers. Strong linkages with resilient economies in the region (Australia and, to a lesser extent, emerging Asia) have helped cushion downturns.

### Policy buffers and macro resilience
- Since the 2008–09 crises, reserve positions improved on balance relative to 2004–07. But more than half of the PICs emerged from the crisis with somewhat less comfortable fiscal buffers (higher debt and larger fiscal deficits) than before the crisis.

### Econometric findings (growth determinants)
- Regression results indicate PICs suffer a disadvantage in per capita GDP growth of about 2 percentage points, compared with an average small state.
- All variables have expected signs: trade openness and a well educated population positively impact real GDP per capita growth; public debt, GDP volatility, and government consumption have negative effects. High government consumption crowds out productive investment.
- Comparative results: small states have grown 1¼ percentage points less than big states (Model 1); after controlling for other variables, PICs have grown by 3 percentage points less than non-small states (Model 2).
- Geographical disadvantage: Once distance (remoteness proxied by distance to the closest continent) is included, the dummies for the PICs and other small states become insignificant (Model 5). The distance coefficient has the expected negative sign, indicating remoteness is a key variable explaining differential growth performance.
- Additional contributing factors: higher fixed government costs, capacity constraints, less openness, and higher GDP volatility relative to other small states also help explain growth differences.

### Policy implications and recommendations
- Rebuild policy buffers while implementing growth-enhancing reforms:
  - Strengthen domestic revenue mobilization to support rebuilding of policy buffers. Revenue compliance is challenging in widely scattered islands. Progress in strengthening revenue collection, including streamlining and simplifying existing tax and customs regimes with technical assistance from development partners, would help create fiscal space for critical development spending.
  - Improve composition of public spending toward education, health, and infrastructure to foster inclusive growth. Public investment in infrastructure could crowd-in private investment, attract FDI, and stimulate tourism. Increasing investment in education would raise potential growth.
  - Implement sound structural policies to enhance long-term resilience and boost growth potential. Growth-oriented structural reforms that enhance the business environment can boost investor confidence and private-sector growth. Proper exploitation and management of enormous untapped marine resources is needed.
  - Strengthen institutions and governance, with emphasis on public finance management reforms to improve expenditure efficiency. Introduce a multi-year budget framework and simple fiscal anchors to balance rebuilding buffers with allocating resources for priority needs, account for capacity constraints, and contain spending pressure.
- Financial sector and inclusion:
  - Increase competition in the banking sector and develop non-bank institutions (finance companies, foreign exchange dealers, micro-credit institutions). Promote financial-inclusion initiatives such as lowering the cost of remittances and mobile phone banking.
- Regional approaches:
  - Pursue regional solutions to mitigate small size and dispersion, increase economies of scale, align regulations and laws, lower transaction costs, and promote exchange of knowledge and best practices. Regional solutions to natural disaster risk insurance could be pursued.
  - Continue progress in fisheries (e.g., Nauru Agreement) to strengthen bargaining power of license-issuing countries and control illegal fishing. Address major barriers to labor and investment. Seasonal employment schemes (New Zealand since 2006, followed by Australia) have generated income opportunities and enhanced skills of Pacific island workers.
- Integration with the region:
  - Further trade and investment integration with Asia and the Pacific should help raise growth potential; proximity to dynamic markets (Australia and emerging Asia) has supported recent PIC recoveries.

### IMF engagement in the region
- Surveillance, programs, technical assistance, cooperation, and outreach: IMF supports PICs through bilateral and cross-country surveillance, analytical work, programs (e.g., Solomon Islands ECF), technical assistance, and cooperation with other institutions.
- Institutional presence: IMF established in September 2010 a regional resident representative office for Pacific Island countries based in Suva (Fiji) and a Pacific Islands Unit at HQ.
- Interdepartmental cooperation: In October 2011 the Asia and Pacific Department, together with African and Western Hemisphere Departments, launched an interdepartmental working group—the Small Island Club—for sharing analytical and policy work on small island states.
- Financial assistance examples: A three-year Extended Credit Facility (ECF) with Solomon Islands began in early December 2012 following a Stand-By Credit Facility (SCF) arrangement. Rapid Access Component of the Exogenous Shocks Facility was approved for Samoa after the 2009 tsunami; Stand-By Arrangement and Exogenous Shocks Facility were approved for Maldives in late 2009.
- Technical assistance and capacity building: The Pacific Financial Technical Assistance Centre (PFTAC) has provided technical assistance and training to Pacific Island countries for almost twenty years. PFTAC expanded to seven advisors and a coordinator since mid-2011. Since December 2012, the IMF Statistics Department has provided technical assistance on external sector statistics funded by Japan for selected small states in the region.

*Source: Box 1. Special Challenges Facing Pacific Islands Micro States (IMF).*

### 41. The Fund has also increased synergies with development partners. World Bank and

### _022013a - 41. The Fund has also increased synergies with development partners. World Bank and

### Synergies with development partners
- The Fund has increased synergies with development partners.
- World Bank and Asian Development Bank colleagues regularly join IMF Article IV missions in the Asia and Pacific small states.
- The Fund co-organized outreach events, including the Pacific seminar co-hosted with the World Bank in Tokyo during the 2012 Annual meetings.
- Fund staff have liaised regularly with World Bank colleagues working on small states and on Pacific Island issues.
- Closer engagement has occurred with other development partners—such as AusAID, the New Zealand aid programme, and the EU—through regular dialogue and participation in development partner meetings in the region.

### Outreach and regional engagement
- The Fund participates regularly in several regional meetings, including the Forum Economic Ministers’ Meeting and the South Pacific Central Bank Governors Meeting.
- The Asia and Pacific Department organized the first high-level regional conference on the Pacific Islands in Samoa in March 2012 on fostering inclusive growth and building resilience to shocks, which brought together all major stakeholders, the private sector, and academia for the first time.

### Agenda going forward: analytical priorities and surveillance
- The agenda will continue to be guided by the authorities’ priorities.
- Possible analytical topics identified:
  - (i) Leveraging regional integration with neighboring countries to achieve sustainable growth. While these countries are remote and scattered, their closest markets are among the most dynamic in the world.
  - (ii) Moving up the value chain to remain competitive in the global economy. While diversification may be a challenge, the potential for tapping fishing resources by establishing joint ventures for marine processing and attracting FDI remains huge.
  - (iii) Strengthening fiscal frameworks in resource-rich countries to achieve inclusive growth. A more inclusive growth model remains a top priority, especially in countries whose commodity wealth does not spill over to the rest of the economy. More inclusive growth will speed up progress toward achieving the Millennium Development Goals and strengthening the fiscal framework would reduce revenue volatility.
- Surveillance recommendation:
  - Despite progress on engagement with the Fund, two-thirds of the Asia and Pacific small states are currently on a 24-month Article IV consultation cycle.
  - Their vulnerability to shocks suggests that more effective surveillance could be achieved by moving them to a 12-month cycle, as for most of the small states in other regions.
- Coordination recommendation:
  - Further coordination with development partners could be pursued to avoid duplication of effort among stakeholders and prevent an excessive burden on the authorities.

### Forthcoming events
- The next IMF regional conference on the Pacific Islands is scheduled for late 2013 and will focus on policies aimed at boosting potential growth.

*Source: ASIA AND PACIFIC SMALL STATES — INTERNATIONAL MONETARY FUND (excerpt).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/np/pp/eng/2013/_022013a.pdf_