## 1. Special Challenges Facing Pacific Islands Micro States

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### Overview
- Assembles figures and tables documenting geographic, economic, fiscal, financial, social, and shock-related characteristics of Asia and Pacific small states, with emphasis on Pacific island micro states.
- Organizes evidence across 37 figures and 6 tables, plus a References section.
- Emphasizes geographic isolation, narrow export bases, fiscal constraints, financial-sector limitations, high volatility, external dependence (tourism, remittances, ODA), and recurrent shocks (natural disasters, terms-of-trade swings).

### Core challenges and structural features
- Small population and dispersion
  - Micro states defined as population of less than 200,000: Kiribati, Marshall Islands, Micronesia, Palau, Samoa, Tonga, and Tuvalu.
  - PICs consist of hundreds of islands over an area occupying 15 percent of the globe’s surface.
  - PICs’ average population is half the average population of other small states outside the Pacific region.
  - Pacific Islands are the most remote countries in the world per the UN liner shipping connectivity index and distance measures.
- High fixed government costs and diseconomies of scale
  - Public services face higher fixed government costs per capita; current government spending as a share of GDP is generally higher in micro states than in other groups.
  - Large dispersion and smallness increase input costs and worsen diseconomies of scale for public goods and services.
- Narrow export and production bases
  - Main exports summarized (Table 2):
    - 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
- Financial sector constraints
  - Financial depth generally below other small states; low access to credit by private sector.
  - High spread between lending and borrowing rates.
  - Commercial banks mainly foreign, well capitalized and highly profitable supported by high non-interest income.
  - Land tenure (communal land) constrains use of land as collateral, limiting credit growth.
  - Mobile financial services expanding in Fiji, Samoa, Solomon Islands, and Tonga.
- Limited market access and monetary arrangements
  - Market access to private capital flows almost nonexistent excluding Fiji and Maldives.
  - Five out of 13 countries do not have a central bank: Kiribati, Marshall Islands, Micronesia, Palau, and Tuvalu.
  - Australian dollar legal tender in Kiribati and Tuvalu; U.S. dollar in Marshall Islands, Micronesia, and Palau.
  - Dollarization or fixed/managed exchange rate regimes reflect high fixed costs of independent monetary policy and weak monetary transmission.

### Shocks, vulnerability, and volatility
- Major shock channels
  - Terms of trade, remittances, tourist flows, and financial channels.
  - Large share of imports are food and fuel (about 50 percent), making PICs vulnerable to global commodity price shocks.
  - Remittances important for Samoa, Tonga, Tuvalu, and to a lesser extent Fiji.
  - Tourism receipts important for Maldives, Palau, Vanuatu, Samoa, and Fiji.
  - Falls in advanced-economy stock prices affect PICs with large trust funds (Kiribati, Marshall Islands, Micronesia, Palau, and Tuvalu).
- Aid and donor composition (2005-11)
  - Australia 41%; United States 22%; Japan 17%; New Zealand 7%; EU 12%; Others 1%.
  - Compact of Free Association: U.S. aid represents over 65 percent of total aid in Palau and 90 percent in Marshall Islands and Micronesia; “Compact grants” scheduled to expire in the 2023/24 fiscal year.
- Natural disasters and climate change exposure
  - 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, Cook Islands).
  - Low-lying coral islands (Kiribati, Maldives, Marshall Islands, Tuvalu) highly vulnerable to sea-level rise and coastal erosion.
  - Costs of climate change and fiscal costs remain largely unestimated for Asia and Pacific small states.
- Frequency and magnitude of shocks
  - Political, terms-of-trade, and natural disaster shocks more frequent in small Pacific Islands than in other low-income small states (events based on 1970-2007).
- Volatility patterns (1990–2010)
  - Asia and Pacific small states exhibit higher volatility than other small states in: real per capita GDP growth, changes in terms of trade, aid flows, current account balance, and revenue.
  - Tuvalu experienced the highest variability among PICs; Timor-Leste and Maldives also had higher GDP volatility than other small Asian states.
  - Aid volatility rose with a drop in European donors and emergence of Australia as main Pacific aid provider; aid in micro states often finances one-off projects.
  - Revenue volatility driven largely by non-tax revenues—particularly fishing license fees, which represent about 40 percent of revenues in micro states.
  - Only 5 out of 13 countries have adopted a multi-year budget framework.
  - Only Timor-Leste has a fiscal rule and a stabilization fund to manage natural resource revenue volatility.

### Growth performance and econometric findings
- Stylized growth facts
  - Since 1990, real GDP per capita (PPP) in the PICs increased less than 25 percent, compared with 45 percent in the Eastern Caribbean Currency Union (ECCU) and more than 30 percent in small states.
  - 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’s GDP increased by about 120 percent (overall) and emerging Asia per capita income grew over 250 percent over the same period.
  - PICs’ annual GDP growth (last 20 years): 2 percent; Asian low-income countries growth: 6 percent; ECCU countries growth: 4 percent; Small states growth: 4½ percent.
- Cross-country regression results (panel regressions, 1990–2010; dependent variable: real per capita growth)
  - PICs suffer a disadvantage in per capita GDP growth of about 2 percentage points compared with an average small state (after controlling for standard variables).
  - Trade openness and a well educated population have a positive impact on real GDP per capita growth.
  - Public debt, GDP volatility, and government consumption do not have the expected positive effect; higher government consumption crowds out productive investment.
  - 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).
  - Once distance (remoteness proxied by distance to the closest continent) is included, the dummies for PICs and other small states become insignificant (Model 5), suggesting distance is a key variable explaining growth differences.
  - Higher fixed government costs, capacity constraints, less openness, and higher GDP volatility relative to other small states also help explain growth differentials.
- Selected regression coefficients (signs and significance preserved)
  - Small states: -0.0126*** (Model 1); -0.0098** (Model 2); -0.0105** (Model 3); -0.0084* (Model 4); -0.0070 (Model 5); -0.0066 (Model 6).
  - PICs: -0.0197** (Model 1); ......-0.0161 (Model 5).
  - Oil exporter: -0.0150** (Model 1); -0.0149*** (Model 2); -0.0150*** (Model 3); -0.0167*** (Model 4); -0.0163*** (Model 5); -0.016*** (Model 6).
  - OECD: -0.0094** (Model 1); -0.0094** (Model 2); -0.0095** (Model 3); -0.0085* (Model 4); -0.0087* (Model 5); -0.0087** (Model 6).
  - Openness: 0.0084*** (Model 1); 0.0079*** (Model 2); 0.0081*** (Model 3); 0.0085*** (Model 4); 0.0081*** (Model 5); 0.0082*** (Model 6).
  - Initial per capita GDP: -0.0017*** (Model 1); -0.0018*** (Model 2); -0.0018*** (Model 3); -0.0017*** (Model 4); -0.0018*** (Model 5); -0.0017*** (Model 6).
  - GDP volatility: -0.4184*** (Model 1); -0.4160*** (Model 2); -0.4178*** (Model 3); -0.4206*** (Model 4); -0.4183*** (Model 5); -0.4200*** (Model 6).
  - Education: 0.0064 (Model 1); 0.0042 (Model 2); 0.0054 (Model 3); 0.0086 (Model 4); 0.0064 (Model 5); 0.0077 (Model 6).
  - Debt to GDP: -0.0089*** (Model 1); -0.0092*** (Model 2); -0.0091*** (Model 3); -0.0088*** (Model 4); -0.0092*** (Model 5); -0.0090*** (Model 6).
  - Government consumption to GDP: -0.0913*** (Model 1); -0.0811*** (Model 2); -0.0876*** (Model 3); -0.0939*** (Model 4); -0.0852*** (Model 5); -0.0905*** (Model 6).
  - Distance: .........-0.0011* (Model 3); -0.0009 (Model 5); -0.0011* (Model 6).
  - Constant terms: 0.0565*** (Model 1); 0.0583*** (Model 2); 0.0574*** (Model 3); 0.0575*** (Model 4); 0.0587*** (Model 5); 0.0581*** (Model 6).
  - Observations: 1,741 (all models).
- Decomposition insights (Table 5 examples)
  - PICs’ lower initial income raises growth by about ½ percentage point (=-2.3*-0.0017).
  - PICs’ lower debt relative to other small states increased growth by about 0.1 percentage point (=-0.113*-0.0088).
  - Negative offsets include lower education, higher distance, higher government consumption/GDP, lower openness and high GDP volatility.
  - Example calculation: higher government consumption relative to GDP effect for PICs: 0.167*-0.0939 = -1.6 percentage points.

### Policy recommendations to raise growth potential and resilience
- Rebuild policy buffers while implementing growth-enhancing reforms
  - Strengthen domestic revenue mobilization:
    - Streamline and simplify tax and customs regimes; strengthen revenue collection with technical assistance.
  - Improve composition of public spending:
    - Prioritize education, health, and infrastructure.
    - Public investment in infrastructure to crowd-in private investment, attract FDI, and stimulate tourism.
  - Sound structural policies:
    - Implement growth-oriented structural reforms to improve business environment and spur private-sector growth.
    - Properly exploit and manage untapped marine resources.
  - Strengthen institutions and governance:
    - Bolster public institutions via public finance management reforms to improve expenditure efficiency.
    - Introduce a multi-year budget framework and simple fiscal anchors to guard against pro-cyclical policies and calibrate spending given capacity constraints.
  - Financial sector development:
    - Increase competition in the banking sector where scope exists.
    - Develop non-bank institutions: finance companies, foreign exchange dealers, and micro-credit institutions.
    - Promote financial-inclusion initiatives such as lowering remittance costs and mobile phone banking.
  - Regional solutions and deeper integration:
    - Pursue regional approaches to increase economies of scale through cooperation and regional alignment of regulations.
    - Explore regional solutions to natural disaster risk insurance.
    - Key regional focus areas: fisheries, information and communication technology, and aviation safety.
    - Seasonal employment schemes (New Zealand since 2006; followed by Australia) as successful examples that generated income and skills.
    - Further integration with Asia and Pacific through trade and investment to raise growth potential given proximity to dynamic markets.

### Selected key statistics and country indicators (as presented)
- Growth and comparative figures
  - PICs’ annual GDP growth (last 20 years): 2 percent.
  - Asian low-income countries growth: 6 percent.
  - ECCU countries growth: 4 percent.
  - Small states growth: 4½ percent.
- Trust fund and GNI/GDP example (Tuvalu)
  - GNI exceeds GDP by 60 percent.
  - Inflation component of earnings: about two-third of total earnings.
  - Inflation component equals about 10 percent of GNI (amount needed annually to maintain real value of the Trust Fund).
- Appendix Table — Selected indicators, 2012 (preserving reported values)
  - Bhutan: GDP 1.90; Population 743; GDP Per Capita (Current US$) 2,556; Real GDP Growth 9.7; CPI Inflation 13.0; Current Account -21.9; Fiscal Balance -4.0; Gross Public Debt 66.1; Reserves 41.2; Openness 103.6.
  - Maldives: GDP 2.22; Population 420; Sea area 923,322; Land area 300; GDP Per Capita 5,273; Real GDP Growth 3.4; CPI Inflation 8.0; Current Account -27.1; Fiscal Balance -12.6; Gross Public Debt 73.3; Reserves 13.7; Openness 206.3.
  - Timor-Leste: GDP 4.21; Population 1,119; Sea area 70,326; Land area 14,874; GDP Per Capita 3,766; Real GDP Growth 10.0; CPI Inflation 11.1; Current Account 45.4; Fiscal Balance 39.9; Gross Public Debt 1.0; Reserves 19.4; Openness 40.5.
  - Fiji: GDP 4.02; Population 899; Sea area 1,290,000; Land area 18,272; GDP Per Capita 4,475; Real GDP Growth 2.4; CPI Inflation 3.5; Current Account -8.6; Fiscal Balance -1.6; Gross Public Debt 51.5; Reserves 22.2; Openness 115.0.
  - Kiribati: GDP 0.18; Population 106; Sea area 3,550,000; Land area 810; GDP Per Capita 1,653; Real GDP Growth 2.5; CPI Inflation 3.0; Current Account -17.6; Fiscal Balance -21.8; Gross Public Debt 40.0; Openness 104.5.
  - Marshall Islands: GDP 0.18; Population 53; Sea area 2,131,000; Land area 181; GDP Per Capita 3,432; Real GDP Growth 1.9; CPI Inflation 5.7; Current Account -6.3; Fiscal Balance -1.1; Gross Public Debt 57.2; Openness 134.5.
  - Micronesia: GDP 0.33; Population 103; Sea area 2,978,000; Land area 701; GDP Per Capita 3,185; Real GDP Growth 1.4; CPI Inflation 5.6; Current Account -15.0; Fiscal Balance 1.2; Gross Public Debt 26.6; Openness 102.4.
  - Palau: GDP 0.23; Population 21; Sea area 629,000; Land area 494; GDP Per Capita 11,183; Real GDP Growth 4.0; CPI Inflation 1.7; Current Account 7.7; Fiscal Balance -2.5; Gross Public Debt 34.2; Openness 156.6.
  - Samoa: GDP 0.68; Population 189; Sea area 120,000; Land area 2,935; GDP Per Capita 3,603; Real GDP Growth 1.3; CPI Inflation 5.5; Current Account -9.9; Fiscal Balance -5.6; Gross Public Debt 80.3; Reserves 23.1; Openness 96.8.
  - Solomon Islands: GDP 1.01; Population 565; Sea area 1,340,000; Land area 28,370; GDP Per Capita 1,786; Real GDP Growth 5.5; CPI Inflation 6.2; Current Account -10.5; Fiscal Balance -0.6; Gross Public Debt 18.2; Reserves 49.9; Openness 125.7.
  - Tonga: GDP 0.47; Population 103; Sea area 700,000; Land area 699; GDP Per Capita 4,557; Real GDP Growth 0.8; CPI Inflation 2.5; Current Account -3.8; Fiscal Balance -3.0; Gross Public Debt 45.7; Reserves 29.9; Openness 67.3.
  - Tuvalu: GDP 0.04; Population 11; Sea area 900,000; Land area 26; GDP Per Capita 3,246; Real GDP Growth 1.2; CPI Inflation 3.5; Current Account -8.6; Fiscal Balance 4.3; Gross Public Debt 43.4; Openness 132.4.
  - Vanuatu: GDP 0.76; Population 250; Sea area 710,000; Land area 12,190; GDP Per Capita 3,039; Real GDP Growth 2.6; CPI Inflation 2.2; Current Account -6.1; Fiscal Balance -3.4; Gross Public Debt 22.5; Reserves 23.9; Openness 103.1.
- Memorandum items
  - Frontier and low-income Asia: GDP total 376; Population total 385,853; GDP Per Capita median 1,160; Real GDP Growth 6.4; CPI Inflation 6.2; Current Account -7.0; Fiscal Balance -3.9; Gross Public Debt 33.3; Reserves 14.0; Openness 110.5.
  - Emerging Asia: GDP total 14,160; Population total 3,098,677; GDP Per Capita median 8,336; Real GDP Growth 4.6; CPI Inflation 3.8; Current Account 2.6; Fiscal Balance -1.7; Gross Public Debt 40.1; Reserves 45.2; Openness 130.7.

*Source: _wp13123 - Appendix Table and Box 1, “Special Challenges Facing Pacific Islands Micro States.”*

### 1. Special Challenges Facing Pacific Islands Micro States  ...............................................18

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

### Overview
- This content unit assembles figures and tables that document geographic, economic, fiscal, financial, social, and shock-related characteristics of small states in the Asia and Pacific region, with emphasis on Pacific island micro states.
- The unit organizes evidence across 37 figures and 6 tables, plus a References section.

### Figures (by theme and focus)
- Population and geography
  - Figure 1: Small States–Asia and Pacific Region: Population, 2011
  - Figure 2: Small States–Asia and Pacific Region: Distance to the Closest Continent
  - Figure 4: Population versus GDP-Weighted Distance
  - Table 1: Geographical Dispersion: Average Sea Distance between Two Inhabitants for the Same Country
- Connectivity and trade
  - Figure 3: Small States–Asia and Pacific Region: Liner Shipping Connectivity Index
  - Figure 7: Small States: Trade Openness
  - Figure 8: Small States–Asia and Pacific Region: Trade Openness
  - Figure 23: Small States–Asia and Pacific Region: Trade Balance of Goods and Services
- Government size and fiscal costs
  - Figure 5: Small States–Asia and Pacific Region: Current Government Expenditure, 2011
  - Figure 6: Small States–Asia and Pacific Region: Cost of Government, 1990–2010
  - Figure 25: Small States–Asia and Pacific Region: Public Debt, 2011
  - Figure 31: Small States–Asia and Pacific Region: Fiscal Volatility, 1990–2010
  - Figure 32: Small States–Asia and Pacific Region: Pro-cyclical Bias in Fiscal Policy, 2005–10
- Financial sector and inclusion
  - Figure 9: Small States–Asia and Pacific Region: Interest Rate Spread of Commercial Banks
  - Figure 10: Small States–Asia and Pacific Region: Domestic Credit to Private Sector
  - Figure 11: Small States–Asia and Pacific Region: Financial Development and Inequality, 1990–10
  - Table 3: Small Pacific Island Countries: Interest and Non-interest Income of Commercial Banks, 2011
- Growth, volatility, and governance
  - Figure 12: Small States–Asia and Pacific Region: Real per Capita GDP Growth and Business Climate, 2000–10
  - Figure 13: Small States–Asia and Pacific Region: Ease of Doing Business Index
  - Figure 26: Small States–Asia and Pacific Region: Volatility of Real per Capita GDP Growth, 1990–2010
  - Figure 27: Small States–Asia and Pacific Region: Real per Capita GDP Volatility and Growth, 1990–2010
  - Figure 28: Small States–Asia and Pacific Region: Volatility of Real per Capital GDP Growth and Governance, 1990–2010
  - Figure 29: Small States–Asia and Pacific Region: Volatility of GDP Growth, Terms of Trade, Aid, and Current Account Balance, 1990–2010
- Social indicators and human development
  - Figure 14: Small States–Asia and Pacific Region: Secondary School Enrollment
  - Figure 15: Selected Asia and Pacific Countries: Lowest Human Development Index (HDI) Rank, 2011
- External resources, aid, and external balances
  - Figure 16: Small States–Asia and Pacific Region: Tourism and Remittances
  - Figure 17: Small States–Asia and Pacific Region: Sovereign and Investment Fund Balances
  - Figure 18: Small States–Asia and Pacific Region: Official Development Aid by OECD Donors
  - Figure 19: Small States–Asia and Pacific Region: Official Development Assistance by Donors
  - Figure 22: Small States–Asia and Pacific Region: External Grants, 2011
  - Figure 24: Small States–Asia and Pacific Region: Current Accounts Excluding Grants
- Natural disasters and shock frequencies
  - Figure 20: Average Impact of National Disasters
  - Figure 21: Small States–Frequencies of Shocks
- Country-level income and growth series
  - Figure 33: Small States: GDP per Capita, 2011
  - Figure 34: Small States: GNI per Capital, 2011
  - Figure 35: Small States–Asia and Pacific Region: Real GDP per Capita Growth
  - Figure 36: Small States–Asia and Pacific Region: Real GDP Growth, 1990–2012
  - Figure 37: Small States–Asia and Pacific Region: Rebuilding Policy Buffers

### Tables (focus and analytical role)
- Table 1: Geographical Dispersion: Average Sea Distance between Two Inhabitants for the Same Country
- Table 2: Small States–Asia and Pacific Region: Main Exports of Goods and Services
- Table 3: Small Pacific Island Countries: Interest and Non-interest Income of Commercial Banks, 2011
- Table 4: Determinants of Real per Capital GDP Growth
- Table 5: Pacific Island Countries: Growth Advantages and Disadvantages
- Table 6: Small States–Asia and Pacific Region: Growth Advantages and Disadvantages

### Analytical emphases implied by the content list
- Geographic isolation and dispersion metrics (Population, Distance to Continent, Geographical Dispersion) underpin discussions of connectivity, transport cost, and trade openness.
- Fiscal size, cost of government, and public debt indicators point to constraints on fiscal space and the role of volatile revenues and pro-cyclical fiscal policy.
- Financial sector indicators (interest spreads, domestic credit, bank income composition) and business climate measures (Ease of Doing Business, business climate indices) illuminate financing constraints and barriers to private sector development.
- Volatility measures (GDP per capita volatility, terms of trade, aid, current account balance, revenue volatility, fiscal volatility) and shocks (natural disasters, frequencies of shocks) underscore vulnerability to external and idiosyncratic shocks and the importance of policy buffers.
- External resource dependence (tourism, remittances, ODA, external grants) and sovereign/investment fund balances highlight exposure to external financing and the role of reserves and funds in smoothing shocks.
- Growth determinants and country-specific advantages/disadvantages are captured in regressions and comparative tables (Table 4, Table 5, Table 6), indicating an empirical basis for diagnosing growth performance.

*Source: _wp13123 - 1. Special Challenges Facing Pacific Islands Micro States*

### Appendix Table

### _wp13123 - Appendix Table

### I. INTRODUCTION
- Small states of the Asia and Pacific region face 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.
- Public services face higher fixed government costs per capita because services must be provided regardless of small population size.
- Low access to credit by the private sector and capacity constraints impede inclusive growth; these challenges are particularly acute in micro states (population of less than 200,000 people).
- Asia and Pacific small states exhibit higher volatility than other small states in: per capita GDP growth, changes in the terms of trade, aid, current account balance, and revenue.
- Econometric result: After controlling for standard variables, Pacific Island Countries (PICs) have a disadvantage in per capita GDP growth of about 2 percentage points compared with an average small state.
- Policy-relevant observations:
  - Five out of 13 countries do not have a central bank.
  - Fiscal policies have sometimes been pro-cyclical.
  - Micro states are subject to more vulnerability and macroeconomic volatility than other Asia-Pacific small states.
  - Despite constraints, some countries have done slightly better than comparators during the recent business cycle due to sound policies and strong linkages with resilient regional economies; some have built policy buffers.
- Policy recommendations (high level from text):
  - Rebuild buffers given high vulnerability to external shocks.
  - Improve composition of public spending toward education, health, and infrastructure to foster inclusive growth.
  - Properly exploit and manage untapped marine resources.
  - Pursue regional solutions, mainly in fisheries, information technology, and aviation safety.
  - Further integration with the Asia and Pacific region to raise growth potential.

### II. CHARACTERISTICS OF SMALL STATES IN THE ASIA AND PACIFIC REGION
- Group definition: APD small states include: 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.
- Geography and remoteness:
  - PICs consist of hundreds of islands over an area occupying 15 percent of the globe’s surface.
  - PICs’ average population is half the average population of other small states outside the Pacific region.
  - The Pacific Islands are the most remote countries in the world per the UN liner shipping connectivity index and distance measures.
- Cost of government and public services:
  - Higher fixed (per capita) government costs relative to other small states; current government spending as a share of GDP is generally higher in micro states than in other groups.
  - Large dispersion and smallness increase input costs and worsen diseconomies of scale for public goods and services (education, justice, social services, infrastructure, institutions).
- Export and production bases (Table 2 summaries preserved):
  - 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
- Economic diversification:
  - Narrow export bases; reliance on tourism (Maldives, Fiji, Samoa, Palau, Vanuatu), fishing (Kiribati, Marshall Islands, Micronesia, Tuvalu), and commodity/energy resources (Bhutan, Solomon Islands, Timor-Leste).
  - Niche or eco-tourism emerging in Kiribati, Marshall Islands, Micronesia. Joint ventures for marine processing noted.
- Trade openness and connectivity:
  - PICs appear less open than comparators but openness has increased recently.
  - Remoteness, underdeveloped infrastructure, and low competitiveness raise transport costs and hinder trade and tourism.
- Financial depth and access to credit:
  - Financial depth generally below that of other small states; low access to credit by private sector.
  - Land tenure (communal land) in Pacific Islands constrains credit growth: land often owned by government or large families, limiting use as collateral.
  - High spread between lending and borrowing rates in the Pacific Islands.
  - Commercial banks in the Pacific Islands—mainly foreign—are well capitalized and highly profitable despite low lending growth, supported by high non-interest income (foreign exchange activities, fees).
- Financial inclusion and recent developments:
  - Mobile phone networks for basic financial services adopted in Fiji, Samoa, Solomon Islands, and Tonga to support private sector growth.
  - Decreasing remittance costs by Australian banks aiding financial intermediation.
- Market access and business environment:
  - International market access is very limited; market access to private capital flows almost nonexistent excluding Fiji and Maldives.
  - World Bank Doing Business indicators: procedures for starting and closing a business are more expensive in small Pacific islands than in other Asia-Pacific small states and Caribbean island countries.
- Policy tools and monetary arrangements:
  - Five out of 13 countries do not have a central bank: Kiribati, Marshall Islands, Micronesia, Palau, and Tuvalu.
  - Australian dollar circulates as legal tender in Kiribati and Tuvalu; U.S. dollar in Marshall Islands, Micronesia, and Palau.
  - Dollarization or fixed/managed exchange rate regimes reflect fixed costs of independent monetary policy and weak monetary transmission (shallow money markets, absence of credit bureaus, small market size).
- Capacity constraints and human development:
  - School enrollment lower than in other small states.
  - Public service capacity constraints in small PICs associated with small size and linked to underperformance in public financial management reforms.
  - Solomon Islands, Fiji, and Vanuatu have taken steps to strengthen public finance management, budget transparency, and accountability.
  - Human development: Of the 12 countries with the lowest rank on the human development index in the region, 6 are small states and 3 are micro states.

### III. MANAGING SHOCKS, VULNERABILITY, AND VOLATILITY
A. Shocks — channels and exposures
- Major shock channels: terms of trade, remittances, tourist flows, and financial channels.
- Commodity and import exposure:
  - All PICs are especially vulnerable to global commodity price shocks—particularly food and fuel—given their large share in total imports (about 50 percent).
  - Terms-of-trade shocks have translated into large output shocks; higher import prices raise production costs and reduce real household income.
- External demand and financial shocks:
  - Contagion channels: remittances (Samoa, Tonga, Tuvalu, and to a lesser extent Fiji) and tourism receipts (Maldives, Palau, Vanuatu, Samoa, and Fiji).
  - Falls in advanced-economy stock prices affect PICs with large trust funds invested offshore (Kiribati, Marshall Islands, Micronesia, Palau, and Tuvalu), as in 2008–09.
- Aid dependence and donor composition:
  - Aid flows proven resilient; Australia is the main donor in the region.
  - Aid composition (2005-11): Australia 41%, United States 22%, Japan 17%, New Zealand 7%, EU 12%, Others 1%.
  - Compact of Free Association: For Marshall Islands, Micronesia, and Palau, U.S. aid represents over 65 percent of total aid in Palau and 90 percent in Marshall Islands and Micronesia; “Compact grants” are scheduled to expire in the 2023/24 fiscal year.
- Natural disasters and climate change:
  - High exposure: 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, Cook Islands).
  - Several small island countries are low-lying coral islands (Kiribati, Maldives, Marshall Islands, Tuvalu), making them highly vulnerable to sea-level rise and coastal erosion.
  - Costs of climate change and fiscal costs remain largely unestimated for Asia and Pacific small states.
- Frequency of shocks:
  - Event analysis shows political, terms-of-trade, and natural disaster shocks are more frequent in small Pacific Islands than in other low-income small states (events based on 1970-2007).

B. Vulnerability
- Reliance on aid and remittances to finance structural trade deficits:
  - Large trade deficits due to small domestic markets and poor resource endowments; most are net importers of energy and food.
  - External grants, 2011 (in percent of GDP): PICs average = 24.1; APD small states average = 22.5; Small states average = 9.5.
- Current account and trade balances:
  - Trade balance of goods and services (2005-11 average) indicates high imports relative to exports for many APD small states; examples show Tuvalu, Micronesia, Kiribati, Marshall Islands with large import shares.
- Debt and fiscal space:
  - ODA has kept debt in check until recent years; since the 2008–09 crisis, debt has increased due to countercyclical fiscal support and new borrowing from Asian emerging markets.
  - As of February 2013 Article IV reports (low-income countries DSA): high risk of debt distress—Kiribati, Maldives, Tonga, Tuvalu; moderate risk—Bhutan, Samoa, Solomon Islands; low risk—Fiji, Vanuatu.
- Vulnerability indices and measurement issues:
  - Becker index (2012), Briguglio (1995), and Commonwealth Secretariat (2000) provide vulnerability rankings based on dimensions like population, arable land, and distance.
  - GNI per capita can be misleading for micro states: fixed government costs imply effective purchasing power is lower than per capita indicators suggest.

C. Volatility
- General finding: Asia and Pacific small states face higher volatility than other small states in per capita GDP growth, terms of trade, aid, current account balance, and revenue.
- GDP per capita volatility:
  - 1990–2010: volatility of GDP per capita higher in Asia and Pacific small states, especially micro states (all PICs).
  - Tuvalu experienced the highest variability among the PICs; Timor-Leste and Maldives also had higher GDP volatility than other small Asian states.
  - Higher output volatility associated with lower economic growth (1990–2010) and lower quality of governance after controlling for other variables.
- Terms of trade, aid, and current account volatility:
  - 1990–2010: terms of trade more volatile than in other small states; aid flows more volatile, especially among micro states.
  - Aid volatility reflects drop in assistance from traditional European donors and emergence of Australia as largest Pacific aid provider; in micro states aid often finances specific one-off projects.
  - Volatility of terms of trade and aid has led to greater current account volatility.
- Revenue volatility and fiscal pro-cyclicality:
  - Revenue volatility is higher in Asia and Pacific small states—especially micro states—relative to other small states.
  - 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.
  - Managing revenue volatility is a major challenge because it can promote fiscal pro-cyclicality (expansionary fiscal policy during upturns and contractionary during downturns).
  - 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 volatility of fiscal revenue and ensure intergenerational equity for natural resource earnings.
- Empirical measures and comparative volatility (1990-2010):
  - Volatility metrics presented as standard deviations and coefficients of variation across groups for: real per capita GDP growth, weighted terms of trade, current account balance, aid to GNI, revenue, tax revenue, non-tax revenue, and fiscal balance.
  - Boxed distributions indicate APD small states and PICs generally have higher medians and wider interquartile ranges for these volatility measures versus non-small states and other small-state groups.
- Fiscal policy bias (2005-10):
  - Charted fiscal impulse versus output gap and fiscal impulse versus change in terms of trade indicate quadrants of pro-cyclical and counter-cyclical policy; many Asia-Pacific small states exhibit pro-cyclical bias.

*Italic: Source — _wp13123 - Appendix Table*

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

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

### Special challenges and vulnerabilities
- More volatility:
  - Micro states face more volatility with respect to their 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 and performance (stylized facts)
- Real GDP per capita and income trends:
  - 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.
  - Emerging Asia’s GDP 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.
- Relative income levels:
  - As of 2011, the average GNI per capita for the PICs was one third the average income of the Caribbean countries.
  - In Tuvalu, GNI exceeds GDP by 60 percent because of sizable government investment income from its sovereign trust fund whose assets are invested abroad.
  - In Tuvalu 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 the trust fund management until 2023/24.
- Low-growth path:
  - 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 their demographics, the underperformance of the PICs, in per capita terms, is also more striking.
- Recent cycle and buffers:
  - While PICs have done slightly better than comparators during the recent business cycle, 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 the downturn in all PICs.
  - Since the 2008–09 crises, some Asia and Pacific small states have made progress in rebuilding policy buffers 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.
  - Their reserve position has improved on balance relative to 2004–07.

### Econometric analysis: determinants of growth
- Main findings from regressions (panel regressions, 1990-2010; dependent variable: real per capita growth):
  - After controlling for standard variables, PICs suffer a disadvantage in per capita GDP growth of about 2 percentage points compared with an average small state.
  - Trade openness and a well educated population have a positive impact on real GDP per capita growth.
  - Public debt, GDP volatility, and government consumption do not have the expected positive effect; higher government consumption crowds out productive investment.
  - 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).
  - Once distance (remoteness proxied by distance to the closest continent) is included in the regression, the dummies for the PICs and other small states become insignificant (Model 5), suggesting distance is a key variable explaining growth differences.
  - Higher fixed government costs, capacity constraints, less openness, and higher GDP volatility relative to other small states also contribute to explain the difference in growth performance.
- Selected regression coefficients (Table 4; signs and statistical significance preserved):
  - Small states: -0.0126*** (Model 1); -0.0098** (Model 2); -0.0105** (Model 3); -0.0084* (Model 4); -0.0070 (Model 5); -0.0066 (Model 6).
  - PICs: -0.0197** (Model 1); ......-0.0161 (Model 5) [as presented].
  - Oil exporter: -0.0150** (Model 1); -0.0149*** (Model 2); -0.0150*** (Model 3); -0.0167*** (Model 4); -0.0163*** (Model 5); -0.016*** (Model 6).
  - OECD: -0.0094** (Model 1); -0.0094** (Model 2); -0.0095** (Model 3); -0.0085* (Model 4); -0.0087* (Model 5); -0.0087** (Model 6).
  - Openness: 0.0084*** (Model 1); 0.0079*** (Model 2); 0.0081*** (Model 3); 0.0085*** (Model 4); 0.0081*** (Model 5); 0.0082*** (Model 6).
  - Initial per capita GDP: -0.0017*** (Model 1); -0.0018*** (Model 2); -0.0018*** (Model 3); -0.0017*** (Model 4); -0.0018*** (Model 5); -0.0017*** (Model 6).
  - GDP volatility: -0.4184*** (Model 1); -0.4160*** (Model 2); -0.4178*** (Model 3); -0.4206*** (Model 4); -0.4183*** (Model 5); -0.4200*** (Model 6).
  - Education: 0.0064 (Model 1); 0.0042 (Model 2); 0.0054 (Model 3); 0.0086 (Model 4); 0.0064 (Model 5); 0.0077 (Model 6).
  - Debt to GDP: -0.0089*** (Model 1); -0.0092*** (Model 2); -0.0091*** (Model 3); -0.0088*** (Model 4); -0.0092*** (Model 5); -0.0090*** (Model 6).
  - Government consumption to GDP: -0.0913*** (Model 1); -0.0811*** (Model 2); -0.0876*** (Model 3); -0.0939*** (Model 4); -0.0852*** (Model 5); -0.0905*** (Model 6).
  - Distance: .........-0.0011* (Model 3); -0.0009 (Model 5); -0.0011* (Model 6).
  - Constant terms: 0.0565*** (Model 1); 0.0583*** (Model 2); 0.0574*** (Model 3); 0.0575*** (Model 4); 0.0587*** (Model 5); 0.0581*** (Model 6).
  - Observations: 1,741 (all models).
- Decomposition (Table 5 and text example):
  - PICs’ lower initial income has a positive effect on growth: about ½ percentage point (=-2.3*-0.0017).
  - PICs’ lower debt level relative to other small states has increased PICs’ growth by about 0.1 percentage point (=-0.113*-0.0088).
  - Negative offsets include: lower education, higher distance, higher government consumption over GDP, lower openness and high GDP volatility.
  - Example: higher government consumption relative to GDP has a large negative growth effect for the PICs: 0.167*-0.0939 = -1.6 percentage points.

### Policy implications: how to raise growth potential and enhance resilience
- Rebuild policy buffers while implementing growth-enhancing reforms:
  - Strengthening domestic revenue mobilization:
    - Revenue compliance is extremely challenging to enforce, especially in islands that are widely scattered.
    - Further progress in strengthening revenue collection, including by streamlining and simplifying existing tax and customs regimes with technical assistance provided by development partners, would help create fiscal space to meet critical development spending needs.
  - Improve composition of public spending:
    - Prioritize education, health, and infrastructure to foster inclusive growth.
    - Public investment in infrastructure could help crowd-in private investment, attract FDI, and stimulate more tourism.
    - Increasing investment in education would raise potential growth.
  - Sound structural policies:
    - Implement growth-oriented structural reforms to enhance the business environment, boost investor confidence, and spur private-sector growth.
    - Asia and Pacific small states have enormous untapped marine resources and further effort is needed to properly exploit and manage them.
  - Strengthen institutions and governance:
    - Bolster public institutions through public finance management reforms to improve expenditure efficiency.
    - Introduce a multi-year budget framework to help bring about realistic fiscal plans and guard against pro-cyclical policies.
    - A multi-year fiscal framework built around simple fiscal anchors could help balance rebuilding buffers and allocating resources for priority needs, and better calibrate the pace of spending given capacity constraints.
  - Financial sector development:
    - Increase competition in the banking sector where scope exists.
    - Develop non-bank institutions: finance companies, foreign exchange dealers, and micro-credit institutions.
    - Promote financial-inclusion initiatives such as lowering the cost of remittances and mobile phone banking.
  - Regional solutions and integration:
    - Pursue regional approaches to mitigate small size and high dispersion by increasing economies of scale through cooperation.
    - Regional alignment of regulations and laws can lower transaction costs and reduce need for country-specific regulatory knowledge.
    - Regional solutions to natural disaster risk insurance could be pursued.
    - Key sectors for regional focus include fisheries, information and communication technology, and aviation safety.
    - Progress example: Nauru Agreement strengthened regional capacity to increase bargaining power of license-issuing countries and regional control to stop illegal fishing.
    - Seasonal employment schemes (New Zealand since 2006; followed by Australia) opened to PICs and Timor-Leste are successful cases of enhanced integration that generated income opportunities and enhanced skills.
  - Further integration with the Asia and Pacific region through trade and investment should help raise growth potential given proximity to dynamic markets and the resilience of Australia and emerging Asia.

### Key statistics (selected country and regional figures as presented)
- Growth and levels:
  - PICs’ annual GDP growth (last 20 years): 2 percent.
  - Asian low-income countries growth: 6 percent.
  - ECCU countries growth: 4 percent.
  - Small states growth: 4½ percent.
- Trust fund and GNI/GDP example (Tuvalu):
  - GNI exceeds GDP by 60 percent.
  - Inflation component of earnings: about two-third of total earnings.
  - Inflation component equals about 10 percent of GNI (amount needed annually to maintain real value of the Trust Fund).
- Examples from Appendix Table—Selected indicators, 2012 (preserving format and numbers as given):
  - Bhutan: GDP 1.90 (In US$ billions); Population 743 (In thousands); GDP Per Capita (Current US$) 2,556; Real GDP Growth 9.7; CPI Inflation 13.0; Current Account -21.9 (In percent of GDP); Fiscal Balance -4.0 (In percent of GDP); Gross Public Debt 66.1 (In percent of GDP); Reserves 41.2 (In months of imports); Openness 103.6.
  - Maldives: GDP 2.22; Population 420; Sea area 923,322 (In km2); Land area 300 (In km2); GDP Per Capita 5,273; Real GDP Growth 3.4; CPI Inflation 8.0; Current Account -27.1; Fiscal Balance -12.6; Gross Public Debt 73.3; Reserves 13.7; Openness 206.3.
  - Timor-Leste: GDP 4.21; Population 1,119; Sea area 70,326; Land area 14,874; GDP Per Capita 3,766; Real GDP Growth 10.0; CPI Inflation 11.1; Current Account 45.4; Fiscal Balance 39.9; Gross Public Debt 1.0; Reserves 19.4; Openness 40.5 (note: Excludes oil exports, which are recorded as income in the balance of payments).
  - Fiji: GDP 4.02; Population 899; Sea area 1,290,000; Land area 18,272; GDP Per Capita 4,475; Real GDP Growth 2.4; CPI Inflation 3.5; Current Account -8.6; Fiscal Balance -1.6; Gross Public Debt 51.5; Reserves 22.2; Openness 115.0.
  - Kiribati: GDP 0.18; Population 106; Sea area 3,550,000; Land area 810; GDP Per Capita 1,653; Real GDP Growth 2.5; CPI Inflation 3.0; Current Account -17.6; Fiscal Balance -21.8; Gross Public Debt 40.0; Reserves ...; Openness 104.5.
  - Marshall Islands: GDP 0.18; Population 53; Sea area 2,131,000; Land area 181; GDP Per Capita 3,432; Real GDP Growth 1.9; CPI Inflation 5.7; Current Account -6.3; Fiscal Balance -1.1; Gross Public Debt 57.2; Reserves ...; Openness 134.5.
  - Micronesia: GDP 0.33; Population 103; Sea area 2,978,000; Land area 701; GDP Per Capita 3,185; Real GDP Growth 1.4; CPI Inflation 5.6; Current Account -15.0; Fiscal Balance 1.2; Gross Public Debt 26.6; Reserves ...; Openness 102.4.
  - Palau: GDP 0.23; Population 21; Sea area 629,000; Land area 494; GDP Per Capita 11,183; Real GDP Growth 4.0; CPI Inflation 1.7; Current Account 7.7; Fiscal Balance -2.5; Gross Public Debt 34.2; Reserves ...; Openness 156.6.
  - Samoa: GDP 0.68; Population 189; Sea area 120,000; Land area 2,935; GDP Per Capita 3,603; Real GDP Growth 1.3; CPI Inflation 5.5; Current Account -9.9; Fiscal Balance -5.6; Gross Public Debt 80.3; Reserves 23.1; Openness 96.8.
  - Solomon Islands: GDP 1.01; Population 565; Sea area 1,340,000; Land area 28,370; GDP Per Capita 1,786; Real GDP Growth 5.5; CPI Inflation 6.2; Current Account -10.5; Fiscal Balance -0.6; Gross Public Debt 18.2; Reserves 49.9; Openness 125.7.
  - Tonga: GDP 0.47; Population 103; Sea area 700,000; Land area 699; GDP Per Capita 4,557; Real GDP Growth 0.8; CPI Inflation 2.5; Current Account -3.8; Fiscal Balance -3.0; Gross Public Debt 45.7; Reserves 29.9; Openness 67.3.
  - Tuvalu: GDP 0.04; Population 11; Sea area 900,000; Land area 26; GDP Per Capita 3,246; Real GDP Growth 1.2; CPI Inflation 3.5; Current Account -8.6; Fiscal Balance 4.3; Gross Public Debt 43.4; Reserves ...; Openness 132.4.
  - Vanuatu: GDP 0.76; Population 250; Sea area 710,000; Land area 12,190; GDP Per Capita 3,039; Real GDP Growth 2.6; CPI Inflation 2.2; Current Account -6.1; Fiscal Balance -3.4; Gross Public Debt 22.5; Reserves 23.9; Openness 103.1.
- Memorandum items:
  - Frontier and low-income Asia: GDP total 376 (In US$ billions); Population total 385,853 (In thousands); GDP Per Capita median 1,160; Real GDP Growth 6.4; CPI Inflation 6.2; Current Account -7.0; Fiscal Balance -3.9; Gross Public Debt 33.3; Reserves 14.0; Openness 110.5.
  - Emerging Asia: GDP total 14,160; Population total 3,098,677; GDP Per Capita median 8,336; Real GDP Growth 4.6; CPI Inflation 3.8; Current Account 2.6; Fiscal Balance -1.7; Gross Public Debt 40.1; Reserves 45.2; Openness 130.7.

*Source: IMF staff analysis in Box 1, “Special Challenges Facing Pacific Islands Micro States,” as presented in the supplied content.*

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