WORLD TRADE
ORGANIZATIONWT/COMTD/SE/W/4
23 July 2002
(02-4066)
Committee on Trade and Development
Dedicated Session
SMALL ECONOMIES:  A LITERATURE REVIEW
Note by the Secretariat
Paragraph 35 of the Doha Ministerial Declaration states that:
"We agree to a work programme, under the auspices of the General Council, to
examine issues relating to the trade of smal l economies.  The objective of this work is
to frame responses to the trade-related issues identified for the fuller integration of
small, vulnerable economies into the multilateral trading system, and not to create a
sub-category of WTO Members.  The General Council shall review the work
programme and make recommendations for action to the Fifth Session of the
Ministerial Conference.".
The General Council, at its meeting of 1 March 2002, instructed the CTD to establish a
programme of work on small economies, to be conducted in Dedicated Sessions1.  The  General
Council also instructed the WTO Secretariat to provide relevant information and factual analysis,
inter alia , on the constraints faced by small economies as well as their shortfalls in institutional and
administrative capacities, including in the area of human resources and the effects of tradeliberalization on small economies.  This note, which has been prepared under the Secretariat's own
responsibility, and which is without prejudice to the positions of Members or to their rights and
obligations under the WTO, aims to respond to aspects of those requests, as well as to give an
overview of how the issue of smallness has been dealt with in the economic literature.
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1 Document WT/L/447.WT/COMTD/SE/W/4
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SMALL ECONOMIES:  A LITERATURE REVIEW
I. INTRODUCTION
1. Small country issues have been analysed in th e literature for more than four decades now
(de Vries, 1973, Kuznets, 1960, Scitovsky, 1960) are among the first works on the topic), but there is
still no general agreement on what "small" means.  Several different measures of size and thresholds
have been proposed.  An appropriate definition of smallness should take into account a variety of
factors including population, per capita income and income distribution (Srinivasan, 1986).  Indeed, a
very poor country can have a large population but still be a small market because of its limited
demand potential.
2. In spite of this, the proxy that has been most widely used in the literature as a measure of
country size is population.  Some have proposed 1.5 million people as a threshold (Commonwealth
Secretariat – World Bank Joint Task Force, 2000), others 5 million or even more (Streeten, 1993,
Collier and Dollar, 1999, Brautigam and Woolcock, 2001), and still others something in between
(Armstrong et al, 1998).
3. Of the 207 countries listed in the World Bank's 2002, World Development Indicators, 63 have
a population of less than 1.5 million and 97 of less than or equal to 5 million.  Thirty-six of these are
island states and nine landlocked countries.  Table A1 in the appendix lists countries with populations
of less than 5 million.  Of the 49 countries classified by the United Nations as least-developed (LDCs)
in 2001, 13 have a population below 1.5 million people, 19 below 5 million and 11 are either
landlocked or island countries (small or very small).  However, small countries are not necessarilypoor countries.  If we take the list of small countries proposed by the Commonwealth Secretariat and
World Bank Joint Task Force on small states (April 2000)
2, only seven countries out of 45 have a per
capita GNP below US$760 (the threshold for a country to be considered low income according to the
World Bank Atlas method) and only 14 are also classified as LDCs (Table A2).
4. Davenport (2001) proposes an alternative definition of smallness which has to do with trade
flows. Small states, despite their high degree of openness, usually represent a very small share of
world trade.  In the author's view, instead of considering plain demographic criteria or building up
vulnerability indexes to select small states, one could simply set a threshold share of world trade and
consider as small all the countries that have an export share lower than the cut-off level.3  T h e  d e
minimis principle can be applied either on aggregate trade flows or on a sectoral basis to take into
account countries that have a small aggregate trade share but are particularly relevant producers of a
specific good. Others (Encontre, 1999) have proposed restricting attention to small island states.These countries, being small and remote, share similar characteristics and needs.
5. Whatever the criteria used to define small states, any list would include countries that are
heterogeneous in some respects and can be easily criticized, since the analysis of common
characteristics turns out to be difficult.  Due to the considerable diversity among small states, it is hard
to find that "one" aspect of smallness that is essential in the characterisation of small economies and
                                                     
2 The Commonwealth Secretariat, World Bank Joint Task  Force report considers countries eligible for
official aid, including one transition economy (Estonia) and developing countries, as listed in the List of Aid
Recipients Used for 1997 and 1998 Flows  issued by the OECD Development Assistance Committee, with a
population of less than 1.5 million. A few larger states (Jamaica, Lesotho, Namibia and Papua New Guinea) are
also included because they share many of the characteristics of small states.
3 One possibility considered by Davenport is to set th e limit share at 0.03 percent of world trade, which
was the former threshold used by the WTO to set the minimum level of WTO budgetary contributions.According to the author, selecting the countries by this criterion would also imply that granting special anddifferential treatment would have negligible trade divers ion and trade creation effects.  One third of the 59 WTO
Members with a population of less than 5 million people have been requested to pay the current minimum
contribution rate of 0.015 percent to the WTO 2002 budget.WT/COMTD/SE/W/4
Page 3
in distinguishing them from large states.  In these circumstances, it is not surprising that a unified
view on small states is still missing.
6. In 1998 a Commonwealth Secretariat and World Bank Joint Task Force (Joint Task Force) on
small states was created with the aim of addressing  the request for special treatment advanced by the
Commonwealth small states.  In addition, the Joint Task Force was also meant to deal with the
transitional problems deriving from changes in the international trading system due to the
implementation of the Uruguay Round Agreements and to the expiration of the European Union's
Lomé IV Convention.  In April 2000, the Joint Task Force issued a report that provides "a unified
framework and a continuing agenda for action and analysis by the states themselves, and by the
international and other organisations that provide external support and influence their development."
7. The reason for the attention devoted to small states is to be found in the general belief that,
due to some particular characteristics, small countries are particularly vulnerable and that, because oftheir inherent weakness, they can be more easily hurt succumb in the process of globalisation.  Yet
there is no unanimity of opinion among researchers on this point.  Some have argued that being small
in a "macro" world is a drawback.  Small states cannot enjoy economies of scale both in production
and in public administration.  They are not competitive internationally and in most cases they cannot
pursue an import substitution policy.  They are particularly vulnerable both to natural disasters andeconomic shocks.  According to other studies, smallness is an asset in a changing and dynamic world.
Small countries can respond quickly and easily to the adjustments required by a changing
international economy.  The decision-making process can be faster and more flexible when the
population is less heterogeneous.  For many small states, social and educational indicators are good,
and GDP growth exceed that of large states.
8. The following sections summarize how small state issues have been analysed in the literature.
Section 2 examines the importance of economies of scale both in the public and in the private sector.
The impact on small economies of external shocks, both economic and natural, is the topic of section
3.  The consequences of being remote and isolated countries are examined in section 4. Section 5 is
devoted to a discussion of indices used to measure vulnerability.  Section 6 addresses the issue ofsmall states in the international environment and section 7 reports on some empirical studies.
II. SMALLNESS AND ECONOMIES OF SCALE
9. In the presence of economies of scale, production of both private and public goods can be
realised at a lower cost if output is sufficiently  large.  Small countries are unlikely to reap scale
economies.
1. Public sector
10. Country size is characterised by an obvious trade-off between economies of scale of large
jurisdictions and the costs due to the heterogeneity of large populations.  Many public services and
government functions are indivisible (the government functions, the judicial system, the provision of
health, education and social services, tax and security administration, etc.) and consequently their per
capita cost is lower when it can be spread over many taxpayers.  On the other hand a large population
also implies congestion and a greater diversity that the government has to deal with.
11. Using a model in which individual preferences and geographical location are related and
people cannot move across borders, Alesina and Spolaore (1997) find that when this trade-off is
explicitly considered, a democratisation process leads to a sub-optimally large number of countries.
Especially in many insular countries, the administration of public services is worsened by the fact that
territories are widely dispersed and the provision of health, education and social services can becomevery expensive.  Due to a lack of resources, small countries often have to rely on education abroad for
more advanced or specialist training, running the risk that trained personnel decide not to go back to
the home country.  Again because of resource scarcity, administrators are often required to deal with
different issues and ministers and senior officials are usually responsible for more diffused andWT/COMTD/SE/W/4
Page 4
complex tasks than in larger countries where financial and personnel resources allow to greater
separation of administrative and professional roles (Farrugia, 1993).  On the other hand, the fact that
administrators act on the basis of a broad vision of the system represents a clear advantage.  To
compensate for the more varied tasks falling to pub lic servants in small states, wages in the public
sector are generally higher in proportion to GDP than is the case in larger developing countries
(31 against the 21 percent; Joint Task Force report, 2000).
2. Private sector
12. Almost by definition small economies may find it difficult to take advantage of economies of
scale in production and distribution (Armstrong et al. , 1993). This translates to high unit costs and
possibly to a reduced degree of competition, since, due to its limited size, the domestic market cannot
support many firms producing in the same sector.  As a consequence, small economies are expected to
have higher prices both of intermediates and final goods.  However, as Srinivasan (1986) notes,population is not necessarily a good measure of market size and even large countries might have a
limited domestic market and suffer from the impossibility of exploiting economies of scale.
13. Besides, the optimal size of a country does not depend only on the presence of economies of
scale, but also on the degree of economic integration.  Suppose a country is completely closed to
international trade.  In the presence of economies of scale its size will matter a lot since market sizewill determine the productivity level of the economy.  On the other hand, if the country is completely
open its size becomes irrelevant since the size of  the market is determined by foreign partners as well.
Being a large country is then not so crucial anymore (Alesina and Spolaore, 1997). Of course, non-
traded goods and services, particularly infrastructures, are not subject to this rule and should they
represent an important share of inputs in traded good production, small state competitiveness ininternational markets might be affected (Srinivasan, 1986).  Research and development activities are
characterised by large economies of scale as well, and smallness therefore has consequences on the
development of local technology.  Hence small states have to rely on technologies produced abroad.
The actual ability to import technological improvem ents can be affected both by the size of the
country and by its geographical remoteness (Milner and Westaway, 1993).
14. Differences in economic structures between small and large states has implications for the
taxation system. Having selected 12 small countries according to three criteria (population of less than
1.5 million, land area below 31000 Km
2 and GDP less than US$1.5 billion) and 11 maxi-states
(population above 25 million, land area more than 700000 Km2 and GDP at least of US$30 billion),
Codrington (1989) finds that on average large countries impose more taxes on income, employment
and property.  Small countries prefer foreign trade and miscellaneous taxes; indeed, at the time of the
research, a few small countries did not even have taxes on individual and corporate income, the samebeing true for taxation of net wealth.  While tax income in the large countries come from a variety of
activities, in small ones 84 percent of tax revenue was raised from international trade and income.
From this evidence the author concludes that differences in size determine differences in the
economic structure and social and administrative organisation, which in turn has implications for the
fiscal structure.  In particular, for several reasons small states are usually more open than large ones.Hence, there are more possibilities of taxing exports and imports, which are also easier to tax than
income, than in large countries.
III. VULNERABILITY
15. The Joint Task Force (2000) reports that the standard deviation of annual real per capita
growth is about 25 percent higher in small states th an in large ones.  This higher volatility can be
attributed to different factors, some related to natural peculiarities of many small states, others to the
specific characteristics of their economy.WT/COMTD/SE/W/4
Page 5
1. Natural shocks
16. Natural disasters hit big and small countries, especially those located in some critical areas of
the world.  However, the impact in terms of per capita costs and per unit of area damage of strong
hurricanes and disruptive earthquakes are much more severe in smaller countries.
17. The World Bank supports a disaster management programme in the Caribbean.  The aim of
this programme is to improve the regulatory framework for disaster mitigation, help involve private
insurance in sharing risks, support the improvement of building techniques and land-use planning,
strengthen the performance of national emergency management agencies and support the training of
local communities and investment in protection of infrastructures and facilities.  In early 2000, several
agencies active in disaster management and mitigation, including the World Bank itself, have been
put together to create a ProVention Consortium with the goal of assisting local governments in
reducing disaster related risks and improving their ability to anticipate and respond to disasters whenthey occur.
18. Countries can protect themselves against natural disasters, for example, by holding an
appropriate amount of foreign reserves that could be used to buy imports in bad periods.  Clearly, any
form of insurance costs something to the economy.   Other more traditional forms of insurance can
turn out to be particularly expensive because insu rance suppliers need to be compensated for the high
uncertainty peculiar to the occurrence of natural disasters.
2. Economic shocks
19. Due to their limited size, domestic markets of small economies cannot support the location of
large-scale industries or the production of goods subject to economies of scale at competitive prices.
Natural resource endowments and labour supply are in most cases constrained.  For all these reasons,the range of products produced in small countries is often limited or products are not prices
competitively.  Hence, small states often show a very high dependence on imports and exports (see
Briguglio, 1995) and, consequently, on foreign market conditions.  Trade to GDP ratios in small
economies are usually much larger than the average (Easterly and Kraay, 2000, Joint Task Force
report, 2000) and exports generally rely on a very narrow range of goods and services and areconcentrated on the markets of a few countries.  These conditions may be associated with high
economic instability.
20. The Joint Task Force report (2000) shows that the trade to GDP ratio is above 110 percent for
small countries (120 percent for the Caribbean and Latin American ones), compared to 38 percent in
all low income countries and 45 percent in all middle income countries.  Tourism is the biggest source
of exports for Caribbean and some Pacific island countries.  In 1996 earnings from tourism were 76
percent of total exports in Saint Lucia, 61 percent in Antigua and Barbuda, 55 percent in Barbados, 51percent in Samoa and 42 percent in Vanuatu (Joint Task Force report, 2000).
4  Exports are
concentrated on a limited number of goods and services. Micronesia, for example, exports mainly fish
(40 percent of total exports), Kiribati copra (34 percent) and Papua New Guinea gold (28 percent).  In
his analysis of small island states (SIDS), Encontre (1999) finds that between 1990 and 1996, six out
of twenty countries experienced a decline in the combined share in total exports of the two majorexported commodities and six an increase. Dominica, Kiribati, Saint Lucia and Saint Vincent and
Grenadine are in the first group, Samoa, Solomon Islands and Tonga in the second. Overall SIDS are
highly specialised; more than three quarters of 46 small island states are either service exporters
(tourism, offshore investment services) or dependent on external rental income (aid, remittances, trust
funds income, etc.).  See Encontre (1999) for details.
21. As shown in section 5, Easterly and Kraay (2000) find that more than the lack of export
diversification, it is the big trade to GDP ratios in income that are responsible for growth volatility in
                                                     
4 The diffusion of tourism can have a huge impact on the domestic economy and ecosystem of small
states. The consequences on the environment of non-indigenous product imports and of the construction of
tourism related facilities can be large.WT/COMTD/SE/W/4
Page 6
micro-states, namely of countries with a population of less than 1 million. Indeed, any volatility in
import and export prices has a strong impact on small open economies.  Hence, even small changes in
the international price of commodities and services can have a big impact on the domestic economy.
Besides the possible negative effects implicit in heavy dependence on international trade, the limited
size of the domestic market at the same time thwarts import-substitution policies and strongly reducesthe ability of the country to diversify its exports.  Lastly, given the negligible volume of trade
compared to the size of the world market, small states have no control on the prices of the products
that are traded with foreign countries.  In other words, small economies cannot affect their terms of
trade.
22. While openness to international trade can be the source of negative effects on small countries'
economies, benefits deriving from participation in international trade should not be ignored. Thanks to
international trade consumers in small states have access to goods and services that would not beprovided by the home market and they can enjoy lower prices. On the production side, domestic
producers are given the opportunity to sell on the world market. This may allow them to specialize
and reap the benefits of economies of scale.
3. Openness to capital flows and international aid
23. One way to reduce the negative effects of exogenous economic and natural shocks affecting
small states would be to share risks with foreign markets, for example by holding assets abroad.
Foreign capital could be used to smooth consumption and reduce negative shocks.  Of course this
works well only if domestic shocks are not strongly correlated with those experienced by the rest of
the world.
5  According to some authors (e.g., Rodr ik, 1998), however, there is no evidence that
countries particularly open to international financia l flows grow faster.  Ope nness to capital flows can
also in itself be a source of additional volatility.
24. Small countries are often perceived as highly risky by foreign investors, especially those
countries that are subject to severe and recurrent natural shocks.  Such countries only have limited
access to international financial borrowing.  Official aid can play an important role in reassuring the
private sector and have a crowding-in effect on priv ate investments (Collier and Dollar, 1999).  Apart
from the high perceived risk, there are other possible reasons that prevent private lenders from
investing their money in small countries.  Costs to collect information about the capacity to repay a
loan can be substantial, especially if the amount of the loan is not too high.  The same holds for the
cost of enforcing contracts that, due to different legal and administrative systems, can in the end be
very high.  The Joint Task Force report (2000) compares official per capita aid received by small
countries in 1991-92 to the same variable in 1997-98 (table 5 page 14).  With the exception of a few
countries such as Marshall Island, Micronesia, Palau, Tonga, Antigua and Barbuda, Bahamas,Barbados, Dominica, Guyana, Suriname, Trinidad and Tobago, Estonia and Malta, there has been a
marked reduction in aid-flows.  Per capita FDI ov er the same period shows the opposite behaviour for
all the countries considered, except Equatorial Guinea, Gabon, Swaziland, Kiribati, Marshall Island,
Samoa, Vanuatu, Antigua and Barbuda, Saint Lucia, Saint Vincent and the Grenadines and Cyprus.
In terms of allocation, almost 80 percent of FDI received by small states went to seven countries:Bahamas, Botswana, Estonia, Equatorial Guinea, Guyana, Malta and Trinidad and Tobago.
25. The World Bank has been rather active in supporting small Pacific and Caribbean island
states.  In particular, the Bank has financed lending programs in areas such as health, education,
transport infrastructure and private sector development in the Pacific and supported plans for disaster
mitigation, risk management and telecommunications sector improvements in the Caribbean. Also theEuropean Union has undertaken many interventions in favour of the ACP countries, and other
developing countries in Asia, Latin America and the Mediterranean.
                                                     
5 Easterly and Kraay (2000) find that this is actually the case and that shocks experienced by small
states are not particularly correlated with the world business cycle.WT/COMTD/SE/W/4
Page 7
IV. DISADVANTAGES RELATED TO THE GEOGRAPHICAL LOCATION
26. Transportation costs for remote island or landlocked countries tend to be higher per unit of
traded goods than for other countries.  In the case of remote islands, for example, only air or sea
transportation, which is usually more expensive than land transportation for small volume shipments,
can be used.  In addition,  cargoes tend to be small, increasing the per-unit cost of traded goods.   Furthermore, remote island or landlocked countries are often far away from the main transportation
routes and have to rely on infrequent transportation services, which can lead to delays and
uncertainties in delivery.  Remoteness and high transport costs can have serious consequences for the
production structure of countries.  In particular, agricultural diversification may be discouraged and
manufacturing activities may be uncompetitive when they depend on imported inputs.  (Encontre,
1999)
27. One way to measure the incidence of transportation costs is by using the ratio of insurance
and freight costs to import values.
6  As stated in the Joint Task Force 2000 final report, the median
value of this ratio for all developing countries is 14 percent, while for small island and landlocked
states it goes from 18 percent for Seychelles and Trinidad and Tobago, to 26 percent for Kiribati.  All
that being said, it must also be noted that transpor t costs, in particular for sea transport, have fallen
steadily in the past decade and that their incidence on exported and imported goods has been reduced.Indeed, in the literature some doubts have been cast on the importance of transportation costs as a
determinant of price level differentials.  Armstrong et al.  (1993) examine the price differences
between the Isle of Man and Northwest England for some retail goods and energy supply.  Even using
a wide definition of transport costs, including extra port-handling costs, additional road haulage costs,
packaging, insurance and damage in transit, they find that "additional freight costs cannot possibly be
held responsible for the whole of the higher price levels prevailing on the Isle of Man" and that the
causes of the price differential have to be found somewhere else.  The same conclusion might not hold
for very remote or landlocked countries.
28. Srinivasan (1986) discusses possible responses to high transportation costs.  Switzerland, for
example, transports high value and low weight products. In Cole's (1993) words, "any producer
seeking world markets has to address the question of distance – the answer is efficiency and
competitiveness".  As a last point, Guillaumont (1999) argues that remoteness and landlockedness,
even when representing a serious handicap to a country's growth, cannot strictly be considered as a
source of vulnerability since these are not unforeseen events.  As will be explained in the next section,
the latter situation is a crucial characteristic of vulnerability.
V. INDICES TO MEASURE VULNERABILITY
29. There have been several attempts to measure the degree of vulnerability deriving from the
different sources described above.  The ultimate aim is to see if small states are particularly vulnerable
to external uncontrollable shocks and, hence, if they are more penalised than large developing
countries because of their limited size. In Guillaumont's (1999) words, "vulnerability means the risk
of being harmed, wounded (negatively affected) by unforeseen  events, in general and in economics as
well" (italics added).  Several questions need to be addressed and clarified when it comes tomeasuring vulnerability.  Should only the immediate negative effects of shocks be considered or also
their impact on growth? In other words, should a st atic definition for vulnerability be adopted or a
dynamic one?  And what kind of shocks should be considered, only natural and economic ones or also
those domestic shocks that are related to the political situation and that, as such, are more controlable
by the country concerned?  As Guillaumont (1999) stresses, the risk of a country being harmed by anexternal shock is not given just by the probability of the shock itself happening.  It also depends on
three different components: the size and the likelihood of the shock, the exposure to the shock and the
ability of the country to react to it.  Part of the vulnerability of countries derives from the economic
policy choices made, and as such, is conjunctural.  What a vulnerability index should measure is
                                                     
6 This is the measure proposed in Atkins, J.P., S. Mazzi and C.D. Easter, 2000, and used also in other
papers.WT/COMTD/SE/W/4
Page 8
structural vulnerability, namely the vulnerability resulting from factors that are independent of the
political will of decision makers.
30. The measurement of the different sources of vulnerability also represents a problem.
Vulnerability to natural disasters is probably the most difficult to measure, both because of the lack of
homogeneous data and because of the inherent difficulties in defining an appropriate proxy.  Severalmeasures have been proposed, but each of them seems to suffer from one weakness or another.  Data
on the number of natural disaster events, for example, are in general reliable and available for a long
time-period, but they do not allow distinction between the different types of events and their impact.
Besides, the crude number of disasters does not capture social factors and mitigation measures that
obviously influence the impact of the natural disaster on the economy.
31. Another approach that has been proposed (Pantin, 1997) is to look at the impact of natural
disasters on some macroeconomic indicators, such as GDP, exports and imports, the rate of inflation,the exchange rate, external debt and gross domestic investment.  The idea is to average the rates of
change in these indicators over three years before  the event and compare this aggregate index to the
same index calculated over the three years after the disaster.  As Crowards (2000) notes, this approach
suffers from a number of problems, the most important of which is the implicit assumption that the
macroeconomic indicators used to build up the index are affected only by the catastrophic event.
32. An alternative index that has often been proposed (Guillaumont, 1999) measures instability in
agricultural production, that is the fluctuations of agriculture output around the trend.  The occurrence
and the severity of natural shocks are likely to affect agriculture production and hence be captured by
out-of-trend variations in output.  On the other hand, it is also true that agriculture production can be
affected by many other factors that have nothing to do with natural disasters.  Besides, Crowardsexpresses some doubts on the appropriateness of this index to reflect wider economic impacts of
catastrophic events; sectors in the economy might react in completely different ways.  Lastly, positive
events, such as increases in prices or technological improvements can increase variability of
agricultural output and be wrongly interpreted as an increase in vulnerability.
33. The monetary value of damage caused by natural disasters (proposed, among others, by
Briguglio, 1995) would be a good measure if it were not for the limited data available.  For the most
part, estimates of the cost  of natural disasters are not available for a sufficiently long time span.
Crowards (2000) proposes to combine the number of people affected by the natural disaster and the
number of deaths.  Both these indices are far from being perfect as a proxy for disaster vulnerability.
In particular, the number of people affected is a relatively good measure of the social and economic
consequences of a disaster, but data on this statistic are nor accurate nor consistent.  On the other
hand, data on deaths suffered as a consequence of a natural disaster are more precise and reliable, butthis is not necessarily a good measure of the impact of a disaster on human activities.  It might well
happen that a natural catastrophe is very severe and has serious economic consequences, but it does
not result in many casualties.
34. According to Guillaumont (1999) an indicator of the structural economic vulnerability of
countries should capture the two main shocks vulnerable countries face, namely natural shocks,proxied by agricultural production, and trade shocks, proxied by the instability of exports.  The index
should also include the exposure of the country to external shocks. One way to consider this is by
weighting the basic indexes by the size of the population.  This suggestion relies on the hypothesis
that countries are more vulnerable the smaller they are.  Lastly, the elementary component indexes
should be aggregated either using the same weight or using weights reflecting the impact of thatcomponent on economic growth, as in Guillaumont and Chauvet (1999).
35. The vulnerability index proposed by the Commonwealth Secretariat
7 composed of three
determinants of income volatility: the lack of  export diversification (measured by the UNCTAD
export diversification index), the extent of export dependence (measured by the export to GDP ratio)
                                                     
7 The Commonwealth vulnerability index is based on Atkins, J.P., S. Mazzi and C.D. Easter, 2000.WT/COMTD/SE/W/4
Page 9
and the impact of natural disasters (given by the share of total population affected by natural
disasters).  The final index is calculated by combining those three indexes and weighing them by
GDP. Table 1 reports 111 countries ranked according to the Commonwealth vulnerability index.
Interestingly, 26 out of 28 most vulnerable countries are small states.
36. Briguglio (1995) proposes an index of economic vulnerability based on three variables: the
volume of trade to GDP ratio as a measure of expo sure to foreign economic conditions, the transport
and freight costs as a percentage of exports as a proxy for remoteness and insularity, and the share of
money damage caused by natural disasters (political ones are excluded) in relation to GDP as an
indicator of disaster proneness.  This index does not include any variable directly measuring
economic performance and its components are not correlated to GDP.  Indeed, the index is meant to
measure the degree of fragility of an economy and not its level of development.  Out of 114 countries
including both developed and developing ones, the small island states regularly show a very highvulnerability index.
VI. GLOBALISATION, TRADE AGREEMENTS AND SMALL STATES
37. In a world in which economic activities are more and more integrated, small economies face
pressure to specialize if they want to avoid the ri sk of remaining at the margin of the global economy.
The technological improvements inherent in the globalisation process offer some opportunities for
many small economies to overcome their weaknesses.  However, there is a general fear that many
small economies will not be able to develop their trading and production capacities and thus risk
marginalization from the global economy.  Trade liberalisation and free movement of capital andTable 1 - Country groups according to the Commonwealth vulnerability index
High Vulnerability Higher Medium
VulnerabilityLower Medium
VulnerabilityLow Vulnerability
Antigua & Barbuda* Angola Bolivia Algeria
Bahamas* Bahrain* Cameroon Argentina
Belize* Barbados* Congo, Dem. Rep. Bangladesh
Bhutan* Benin Costa Rica Brazil
Cape Verde* Botswana* Côte d'Ivoire Chile
Comoros* Burkina Faso Cyprus* China
Djibouti* Burundi Dominican Rep. Colombia
Dominica* Central Afr. Rep. Ecuador Agypt
Equatorial Guinea* Chad El Salvador Guatemala
Fiji* Congo Ethiopia India
Gambia* Gabon* Ghana Indonesia
Grenada* Haiti Guinea Iran
Guyana* Honduras Jordan Libya
Kiribati* Jamaica Kenya Malaysia
Lesotho Malawi Madagascar Mexico
Maldives* Mali Nepal Morocco
Mauritania Malta* Oman Myanmar
Samoa* Mauritius* Panama Nigeria
Sao Tomé & Principe* Mozambique Paraguay Pakistan
Seychelles* Namibia Senegal Peru
Solomon Islands* Nicaragua Sri Lanka Philippines
St. Kitts & Nevis* Niger Sudan Singapore
St. Lucia* Papua New Guinea Trinidad & Tobago* South Africa
St. Vincent &  Gren.* Rwanda Tunisia Syria
Suriname* Sierra Leone Uganda Thailand
Swaziland* Tanzania Yemen Turkey
Tonga* Togo Zimbabwe Uruguay
Vanuatu* Zambia Venezuela
* = small state
Source: Commonwealth Secretariat and World Bank (2000), Table 6, p. 22.WT/COMTD/SE/W/4
Page 10
people play an important role in this context.  Several small states are part of different trade
agreements and many of the products made in small economies and exported to developed countries
are subject to special trading status.  At the same time, with the reduction of tariffs on a most favoured
nation basis, trade preferences granted to small economies are going to be eroded, representing a real
challenge for small economies.
1. Globalisation
38. Globalisation is a complex phenomenon that brings both opportunities and challenges for
small economies.  On one side, the changes imposed by rapid technological innovation and deepening
economic integration may represent a problem for countries that are not rich in natural resources and
have limited technological and production capabilities.  On the other hand, these very same
phenomena may create new opportunities for countries that see the importance of their remoteness
and isolation reduced thanks to trade integration and improvements in communication technology. Inorder to profit fully from the opportunities offered by the process of globalisation, small countries
have to provide the right environment.  External support, both in terms of financial aid and technical
advice, can be helpful.
39. The Joint Task Force report identifies two main areas offering opportunities for the
integration of small countries into the new global system: the provision of financial services andinformation technology and e-commerce.  As far as the first is concerned, there are two major
concerns at the international level, one being the fight against money laundering, the other the
negative effects of harmful forms of tax competition. Both topics are subject to discussion in the
international arena, in particular at the OECD.
8
40. On the production side, small state firms have to be ready to recognise rapidly the
opportunities offered by the creation of new goods and services and flexible enough to adopt the
necessary changes to respond to them.  Corporate alliances can be particularly useful for small firms
to overcome their weakness in size.  Improvemen t of the workforce skills and of human capital
quality is another crucial step to be undertaken if firms in small states want to be part of the global
economy.
41. Small countries can implement two alternativ e models of activities to improve their
competitiveness in an integrating world (Encontre, 1999).  They can either re-specialise in activities
that are "globally" competitive and to do so they ty pically need to attract foreign investments, or they
can specialise in those goods or services that are particular to the country and look for a niche in the
international market.  Both these strategies may be difficult to pursue.  The production of "globally"
competitive goods and services has often had a strong environmental impact, and niches have not
always been easy to identify.  Encontre concludes that both approaches have some merit and can beused at the same time in order to increase small countries' integration into the global economy.
2. Trade agreements
42. As mentioned above, several small economies are involved in regional multilateral integration
agreements. The most important among these are the arrangements between the European
Communities and the African, Caribbean and Pacific (ACP) countries, the CARIBICAN, betweenCanada and the Commonwealth Caribbean countries, the South Pacific Regional Trade and Economic
Cooperation Agreement (SPARTECA), between Aust ralia, New Zealand and Pacific islands, the
Caribbean Community and Common Market (CARICOM).   (See Schiff, 2001, for a complete list of
regional integration agreements involving small countries).  A recent paper by Schiff (2001) examines
closely the advantages and disadvantages for small states of being involved in these groups.  Theauthor recognises three types of regional agreements: South-South Regional Integration Agreements
                                                     
8 The OECD Forum on Harmful Tax Competition and the Financial Stability Forum deal with these
issues.WT/COMTD/SE/W/4
Page 11
(RIAs), South-South Regional Coop eration (on public goods and international negotiations) and
North-South Regional Integration Agreements.
43. As far as South-South RIAs are concerned, it is widely recognised that when trade policy with
respect to the rest of the world remains unchanged, members of the agreement may actually
experience a welfare reduction due to trade diversion phenomena (see also Schiff 1996).  Under thesecircumstances, it will most likely be smaller and poorer countries that lose out to larger ones within
regional groupings.  Unless some sort of compensatory mechanism is put in place or the common
external tariff is reduced, these intra-bloc transfers are likely to create tension in the group and
eventually cause the agreement to break down (this was the case for the East African Community and
for the Central American Common Market – see Schiff, 2001, for details).  Regional cooperation on
public goods (water, infrastructure, environment and energy sources, for example) or on international
negotiations, on the contrary, cannot be but beneficial for small countries.  At the international level,the creation of a regional grouping of countries sharing the same needs increases the bargaining power
of states that would otherwise be weak, if taken individually, and helps in reducing the fixed costs of
negotiations that for individual small countries might be unaffordable.
9
44. Small countries are also involved in many North-South regional agreements. The most
important of these is probably the one between the European Communities and 71 African, Caribbeanand Pacific (ACP) countries, which has taken the form of successive Conventions.  The first
Convention was signed in 1975 and was subsequently renewed on a regular basis until the most recent
renewal in 1995 (Lomé IV).  Based on this agreement, extensive duty-free market access was granted
to ACP countries in the EC market.  The lapse of the Lomé IV Convention in 2000 and the coming
into force of post-Lomé agreements (the Cotonou Agreement) between the European Communitiesand the ACP countries represents a real challenge for small states.  Lastly, an increasing number of
small countries are becoming members of the WTO.  Of the 45 countries in the Joint Task Force list,
27 are WTO Members and eight are observers (Table A2).
45. The JTF report (2000) identifies several types of external support that could be particularly
helpful for small countries to meet the challenge of integrating into the world trading system.  Givingsupport for the improvement of human capital and assisting in the reallocation of resources from
sectors that have become unprofitable in the new international context to new, more productive
sectors, are among the most important ones.  The Joint Task Force advocates the adoption of special
treatment for small states in the WTO.  In their wo rds, "… the special characteristics and vulnerability
of many small states should be recognised as justifying special consideration by the international
system to deal with those issues that are crucial to the transformation of their economies, such as
length of transition periods".  The report also argues for enhanced financial and technical assistance.
VII. EMPIRICAL EVIDENCE
46. Because of all the drawbacks small states face, it has been suggested that they grow less
rapidly and show lower development levels than larger countries.  However, the empirical evidence
does not always confirm this hypothesis, indicating that the advantages of being small that have been
identified in theory (such as greater homogeneity and social cohesion, flexibility in the decision-making process and in the response to changes,  greater openness to trade) might mitigate the
disadvantages.  As in theory there is no clear characterisation of what "small state" means, applied
investigations suffer from the same difficulty, and studies adopt different definitions of smallness and
focus on different groups of countries.
10
47. Easterly and Kraay (2000), for example, examine the performance of 33 micro-states
(countries with a population of 1 million or less), compared to the performance of small and large
                                                     
9 A successful example of these kind of cooperations is the CARICOM, that has been involved in ACP-
EU, GATT/WTO, UNCTAD and UNCLOS negotiations, just to cite some of them.
10 Data availability is a serious problem in these kinds of studies. As several empirical papers underline,
for many of the smallest states even data on per capita GDP are either not available or not comparable with
other countries' data sets.WT/COMTD/SE/W/4
Page 12
states.  They find that "micro-states have on average higher income and productivity levels than small
states, and grow no more slowly than large states".  One might think that this result is triggered by the
presence of western countries, such as Luxembourg and Iceland, or oil producers, such as Qatar and
Bahrain.  However, micro-states turn out to be 50 percent richer than other states even when
controlling for location by continent and oil production.  In addition, micro-states seem to performbetter than other countries when it comes to quality of life indicators such as life expectancy (about
four years higher) and infant mortality (lower by 22 per thousand).  Moving from output levels to
growth rates, data do not support the prediction of a scale effect and, even if they show a large output
volatility, which  definitely has a negative impact on growth performance, small states do not seem to
have any growth disadvantage compared to other states.  According to the authors this is due to the
fact that output volatility is more than compensated by other advantages of smallness.  In particular,
micro-states are very open to trade and have high educational attainment levels.  Even if openness totrade can be a source of output volatility in itself, the empirical evidence shows that the positive
impact of trade openness offsets the negative influe nces.  Going deeper in the analysis of the impact
of trade openness on micro-states' economies, Easterly and Kraay also question the view that the high
terms of trade volatility to which smaller states are subject is mainly due to their high specialisation in
international trade.  They argue that high volatilit y is most probably due to large trade to GDP ratios
that amplify the effects of changes in import and export prices.
48. The fact that size is not a significant determinant of countries' growth performance has been
found in other empirical studies.  Armstrong, Kervenoael, Li and Read (1998) estimate a simple
growth equation in which per capita GNP growth is a function of initial per capita GNP, agriculture
and industry shares of total GDP, a series of regi onal influences, and population.  Using data on 133
countries over the 1980-1993 period, they find that the country size variable is insignificant.  This
result has proved robust when applied to alternative data sets.  Going further in the analysis, the
authors find that small states (i.e. states with less that 3 millions of people in this case) do not
constitute a homogeneous group.  When compared to the average GDP level of the regions they
belong to, some small states perform better than the average, others worse, indicating that they do nothave some peculiar characteristics making them a distinct group as a whole and that, on the contrary,
there is a lot of diversity among them. This is true also if micro-states are compared to the
performance of adjacent countries.  The next step is to try to explain the cause of the differences
among small states.  The hypothesis of Armstrong et al., confirmed by the data, is that sectoral
specialisation plays a role. In particular states specialising in tourism and financial services or having
an unusually large endowment of a valuable primar y resource show higher per capita GNP.  Other
factors such as regional location and the agriculture to GDP ratio also seem to influence the GDP ofsmall states.  In particular, countries that are located in poor regions tend to be poor as do those that
have a high agriculture to GDP ratio.  Surprisingly, insularity and specialisation in manufacturing are
not significant determinant of small country performance.
49. Collier and Dollar (1999) stress the importance of macroeconomic stability and good
institutions for small states’ economic performance.  Using a sample of about 90 small (with apopulation of less than 5 millions) and large countries, they show that the effectiveness of financial
aid in reducing poverty depends on the economic policies undertaken by the recipient, confirming the
main conclusion in World Bank's policy research report "Assessing Aid" (1998).
11  In the context of a
healthy political and macroeconomic environment, foreign aid also has a “crowding in” effect on
private investments that would not otherwise be attracted by smaller states, which are in generalperceived as riskier by the private sector.  The evidence shows that small and large countries do not
differ in terms of policy quality.
12  Hence, poor institutions and bad economic management are not
peculiar to states according to size.  What is st atistically significant is the correlation between good
policy and growth performance, both for small an d large states. Nevertheless, it seems that the
                                                     
11 This is a general result, valid also for large states , and is in line with the previous literature on the
subject. See, e.g., Burniside and Dollar (1997) and Collier and Dollar (1998), Dollar and Svensson (1998).
12 Policy quality is measured by the Country Policy and Institutional Assessment (CPIA) index of the
World Bank. This is a composite index rating countries according to several aspects related to macroeconomic
policy, structural measures, equity and safety net policies, public sector management and economic governance.WT/COMTD/SE/W/4
Page 13
allocation of aid is correlated to country size; in 1990-1996 small countries received a share of aid to
GDP on average 1% higher than the aid flowing into large states, independently of their policy
performance.13
50. Brautigam and Woolcock (2001) also find that state capacity level and management of social
conflicts are crucial for the success of small states.  They underline the fact that, in a context ofglobalisation, smallness can be an asset and under certain conditions smaller states can adjust more
rapidly to changing situations.  The quality of institutions is crucial and is what really distinguishes
between small countries that succeed and those that do not.  A simple comparison between 102 small
states and 105 large ones (5 million being the cut off point) shows that small countries are
characterised by relatively higher trade volumes, foreign direct investment, economic inequality,
levels of foreign aid, and growth volatility.  When controlling for the quality of institutions and
standard socio-economic variables, small states remain significantly different from large ones on twodimensions: growth volatility and aid share.  When restricting the analysis to the small state sample, it
is shown that superior state capacity is positively related to growth rates and that conflict management
and state capacity are positively related to growth stability.
1. Concluding remarks51. Drawing a conclusion on what "small state" means is not easy.  As shown in the previous
sections, there is no unanimity on what the most relevant characteristics of small economies are, nor
on which variables are the most appropriate to measure country size and what cut-off points should be
used.  Conclusions in the empirical literature tend to be somewhat contradictory and inconclusive in a
number of important points.
52. Each small economy is unique. However, in general small states are characterised by higher
GDP volatility, greater openness to trade, higher per capita international aid and more concentrated
production and export structures.  At the same time, small states do not perform badly in terms of
GDP levels, growth rates, social, health and edu cational indicators, cohesion variables and greater
flexibility in the decision-making process.
53. There is also ambiguity regarding what globalisation and integration in the international
economy represent for small states. According to some analysts, globalisation means a real
opportunity for countries that suffer from remoteness and isolation.  New communication
technologies and improvements in transportation means that remoteness and isolation become less
stringent constraints and small states can avail themselves of new opportunities.  Others argue that
small economies are too weak and vulnerable to be able to survive if integrated now into the global
economy.  They fear that small economies would succumb if they have to face internationalcompetition without enjoying any form of protection.  A number of these contrast in emphasis and
conclusions can only be addressed by unbundling country groupings and focusing more closely on the
specifics of realities facing individual economies.
                                                     
13 The fact that aid allocation does not depend upon the policy environment of the recipient is actually a
general result and holds also for large countries (see Collier and Dollar, 1998 and Alesina and Dollar, 1998).Aid giving decisions often follow strategic and political considerations. That is why, for example a former
colony typically receives higher financial aid than other countries with the same level of poverty and better
political conditions, but without a past as a colony.WT/COMTD/SE/W/4
Page 14
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Page 20
Appendix
Table A1 - List of small states (less than 5 million people)
Country Population
(Thousands)
(2000)GNI per capita
in US dollars
(2000)Landlocked Island LDC
Albania 3400 1120
American Samoa 65 .. yes
Andorra 67 ..
Antigua and Barbuda 68 9440 yes
Armenia 3800 520 yes
Aruba 101 .. yes
Bahamas, The 303 14960 yes
Bahrain 691 .. yes
Barbados 267 9250 yes
Belize 240 3110
Bermuda 63 .. yes
Bhutan 805 590 yes yes
Bosnia and Herzegovina 4000 1230
Botswana 900 3300 yes
Brunei 338 ..
Cape Verde 441 1330 yes yes
Cayman Islands 35 .. yes
Central African Republic 3700 280 yes yes
Channel Islands 149 ..
Comoros 558 380 yes yes
Congo, Rep. of 3000 570
Costa Rica 3800 3810
Croatia 4400 4620
Cyprus 757 12370 yes
Djibouti 632 880 yes
Dominica 73 .. yes
Equatorial Guinea 457 800 yes
Eritrea 4100 170 yes
Estonia 1400 3580
Faeroe Islands 45 ..
Fiji 812 1820 yes
French Polynesia 235 17290
Gabon 1200 3190
Gambia, The 1300 340 yes
Greenland 56 ..
Grenada 98 3770 yes
Guam 155 .. yes
Guinea-Bissau 1200 180 yes
Guyana 761 860
Iceland 281 30390
Ireland 3800 22960
Isle of Man 75 ..
Jamaica 2600 2610 yes
Jordan 4900 1710
Kiribati 91 950 yes yesWT/COMTD/SE/W/4
Page 21
Country Population
(Thousands)
(2000)GNI per capita
in US dollars
(2000)Landlocked Island LDC
Kuwait 2000 18030
Kyrgyz Republic 4900 270 yes
Latvia 2400 2920
Lebanon 4300 4010
Lesotho 2000 580 yes yes
Liberia 3100 .. yes
Liechtenstein 32 ..
Lithuania 3700 2930
Luxembourg 438 42060
Macao, China 438 14580
Macedonia, FYR 2000 1820 yes
Maldives 276 1960 yes yes
Malta 390 9120 yes
Marshall Islands 52 1970 yes
Mauritania 2700 370 yes
Mauritius 1200 3750 yes
Mayotte 145 ..
Micronesia, Fed. Sts. 118 2110 yes
Moldova 4300 400
Monaco 32 ..
Mongolia 2400 390 yes
Namibia 1800 2030
Netherlands Antilles 215 .. yes
New Caledonia 213 15060
New Zealand 3800 12990
Northern Mariana Islands 72 .. yes
Norway 4500 34530
Oman 2400 ..
Palau 19 .. yes
Panama 2900 3260
Puerto Rico 3900 .. yes
Qatar 585 ..
Samoa 170 1450 yes yes
San Marino 27 ..
Sao Tome and Principe 148 290 yes yes
Seychelles 81 7050 yes
Singapore 4000 24740
Slovenia 2000 10050
Solomon Islands 447 620 yes yes
St. Kitts and Nevis 41 6570 yes
St. Lucia 156 4120 yes
St. Vincent and
   the Grenadines 115 2720 yes
Suriname 417 1890
Swaziland 1000 1390 yes
Togo 4500 290 yes
Tonga 100 1660 yes
Trinidad and Tobago 1300 4930 yes
United Arab Emirates 2900 ..WT/COMTD/SE/W/4
Page 22
Country Population
(Thousands)
(2000)GNI per capita
in US dollars
(2000)Landlocked Island LDC
Uruguay 3300 6000
Vanuatu 197 1150 yes yes
Virgin Islands 121 ..
West Bank and Gaza 3000 1660
Source: World Bank (2002), World Development Indicators and World Bank Atlas .
Note: .. not available
According to World Development Indicators 2002, the following countries' population recently increased to or
above 5 millions:  Nicaragua, Papua New Guinea, Sierra Leone, Turkmenistan.WT/COMTD/SE/W/4
Page 23
Table A2 - Population and per capita GNP of small states in 1998.
List proposed by the Commonwealth Secretariat–World Bank Joint Task Force on Small States
(April 2000 Report)
Country WTO Also LDC Population
(thousands)Per capita GNP
in US$
African Region
Botswana * Yes 1,562 3,070
Cape Verde ° obs. Yes 416 1,200
Comoros ° Yes 531 370
Djibouti Yes Yes 636 c/
Equatorial Guinea Yes 431 1,110
Gabon Yes 1,180 4,170
Gambia, The Yes Yes 1,216 340
Guinea-Bissau Yes Yes 1,161 160
Mauritius ° Yes 1,160 3,730
São Tomé & Principe ° obs. Yes 142 270
Seychelles ° obs. 79 6,420
Swaziland * Yes 989 1,400
East Asia and Pacific Region
BruneiCook Islands °
Fiji °
Kiribati °
Marshall Islands °
Micronesia, Fed. Sts. °Nauru °
Niue °
Palau °
Samoa °
Solomon Islands °Tonga °
Tuvalu °
Vanuatu °Yes
Yes
obs.
Yes
obs.
obs.Yes
Yes
Yes
Yes
Yes315
20
790
86
62
113
11
2
19
169
416
99
11
183a/
4,521
2,210
1,170
1,540
1,800
b/
..
b/
1,070
760
1,750
1,150
1,260
Latin America and Caribbean Region
Antigua and Barbuda °Bahamas, The °
Barbados °
BelizeDominica °
Grenada °
Guyana
St. Kitts and Nevis °
St. Lucia °St.Vincent and the
  Grenadines
 °
SurinameTrinidad and Tobago °Yes
obs.
Yes
YesYes
Yes
Yes
Yes
Yes
Yes
Yes
Yes67
294
266
239
73
96
849
41
152
113
412
1,2858,450
a/
b/
2,6603,150
3,250
780
6,190
3,660
2,560
1,660
4,520WT/COMTD/SE/W/4
Page 24
Country WTO Also LDC Population
(thousands)Per capita GNP
in US$
Other Regions
Bahrain °Bhutan *
Cyprus °
Estonia
Maldives °Malta °
QatarYes
obs.
Yes
Yes
YesYes
YesYes
Yes643
759
753
1,450
263377
7427,640
470
11,920
3,360
1,130
10,100
a/
Source:  World Bank (2001) World Developm ent Indicators and World Bank database. Classification according
to 1998 GNP per capita (GDP for Cook Islands), calculated using the World Bank Atlas method:
a/ High income economy (per capita GNP $9,631 or more).
b/ Upper middle income economy (per capita GNP $3,031-$9,630).c/ Lower middle income economy (per capita GNP $761-$3,030).d/ Low income economy (per capita GNP $760 or less).
.. When not available.
* Land-locked country.° Island country.
__________