From Crisis to Stability: How Small States Can Tackle Debt and Climate Threats

Small states face significant fiscal challenges, exacerbated by the COVID-19 pandemic, economic shocks, and climate-related natural disasters. To overcome rising debt and vulnerabilities, comprehensive fiscal reforms and international cooperation are essential for building resilience and ensuring long-term sustainability.

A recent Policy Research Working Paper published by the World Bank's Development Economics Prospects Group, titled "Fiscal Challenges in Small States: Weathering Storms, Rebuilding Resilience," explores the significant fiscal vulnerabilities small states face, especially in the wake of the COVID-19 pandemic and subsequent global economic shocks. Authored by Samuel Hill and Jeetendra Khadan, the paper delves into how small states, defined as those with populations around 1.5 million or fewer, have been disproportionately affected by the pandemic. These countries, already grappling with longstanding fiscal difficulties, saw their fiscal and debt positions worsen dramatically. The global crisis exacerbated existing weaknesses, including volatile revenue sources, high trade openness, and economic dependence on a few key sectors such as tourism and commodities. Around 40% of the 35 emerging market and developing economies (EMDEs) classified as small states are either in debt distress or at high risk of falling into it, a figure that is roughly twice as high as for other EMDEs.

Economic Contractions and Rising Debt

The pandemic led to deep economic contractions in many small states, with slow recoveries as governments implemented extensive fiscal measures to support households and firms. This, combined with declining revenues, significantly widened fiscal deficits, pushing public debt to unsustainable levels in many countries. The paper highlights that on average, government debt in small states stood at 57% of GDP between 2011 and 2023, with one-third of this debt increase occurring after the pandemic. The slowdown in key sectors like tourism devastated small states reliant on such revenues, and some countries also experienced sharp declines in commodity prices, further worsening their economic outlook. Small states' high trade openness and dependence on limited sectors of comparative advantage often linked to tourism or commodity exports make their economies highly vulnerable to external shocks, resulting in greater output volatility than in larger EMDEs.

The Growing Threat of Natural Disasters

One of the most pressing challenges small states face is their exposure to natural disasters, which have become more frequent and intense due to climate change. Many small states, particularly island nations, are increasingly vulnerable to costly natural disasters such as storms and hurricanes, which can cripple their economies. For instance, the paper points out that natural disasters can reduce economic growth, lead to more volatile revenues, and push government spending higher for disaster recovery efforts. In fact, after a natural disaster, fiscal balances in small states deteriorate by an average of 1.8 percentage points within three years, and government debt typically increases by six percentage points relative to GDP. Additionally, some small states are facing existential threats from rising sea levels and coastal erosion, particularly low-lying nations such as Kiribati, Maldives, the Marshall Islands, and Tuvalu. These challenges underscore the urgent need for these countries to invest in climate change adaptation and build more resilient infrastructure, but such investments are difficult to finance given their fiscal constraints.

Comprehensive Fiscal Reforms Are Essential

The paper calls for comprehensive fiscal reforms to address these mounting challenges. It emphasizes that small states must strike a delicate balance between maintaining fiscal sustainability and investing in critical areas such as human capital and climate-resilient infrastructure. One of the key recommendations is to diversify revenue sources by shifting toward a more stable and secure tax base, as many small states currently rely on volatile or unreliable income streams like tourism and sovereign rents. The report also highlights the need for improved spending efficiency, particularly in areas like public enterprises, subsidies, and the public wage bill. Reforms to fiscal frameworks, including better utilization of fiscal rules and the establishment of sovereign wealth funds, are seen as essential to creating fiscal buffers that can absorb future shocks.

The Role of International Cooperation

International cooperation is another crucial element in helping small states weather these challenges. The global community can play a significant role by supporting small states through financial assistance, technical support, and efforts to bolster climate resilience. This includes the potential for greater coordination on global fiscal policies and debt relief initiatives to alleviate the growing debt burden. The authors argue that well-targeted international policies can help small states strengthen their fiscal management and improve access to funding for key investment areas, particularly in climate change adaptation and resilience building. Small states' ability to recover from shocks and build long-term economic sustainability will depend in large part on their ability to mobilize global support while implementing necessary domestic reforms.

A Path Forward for Small States

The report paints a clear picture of the complex fiscal environment small states are navigating. Rising debt levels, fiscal deficits, and exposure to natural disasters have created significant obstacles to sustainable development. To overcome these challenges, small states need a multi-pronged approach that includes domestic fiscal reforms, international cooperation, and investment in resilient infrastructure. The authors underscore that while these obstacles are substantial, they are not insurmountable. With the right mix of policy reforms and global support, small states can rebuild fiscal resilience, reduce their vulnerability to external shocks, and ensure long-term development.