Fiscal Vulnerability and Resilience in Small Island Developing States: Structural Determinants, Empirical Evidence, and Policy Responses

Overview & Synopsis

Small Island Developing States show a unique and acute form of fiscal vulnerability that distinguishes them from other economies. This note argues that the fiscal precarity of SIDS is not only a consequence of external shocks but is fundamentally rooted in a set of deeply embedded structural characteristics, including extreme economic concentration, inherent limitations on domestic revenue mobilization, expenditure rigidities driven by diseconomies of scale, and unparalleled exposure to climate-related events. Moreover, many SIDS are data poor, or data is available with a significant lag. We use a mixed-methods approach, combining a structural analysis with econometric modeling, including a Local Projection Model for the fiscal impact of shocks and a stochastic Fiscal Sustainability Analysis framework, to dissect these vulnerabilities. For when a shock hits, we provide an approach to nowcast the impact on GDP. We do so using satellite-derived night lights data as a high-frequency proxy for economic activity. The mixed-methods analysis shows that conventional fiscal consolidation measures are insufficient. Instead, a paradigm shift is required, focusing on building structural resilience through a combination of innovative risk-transfer instruments (e.g., CAT DDOs), robust ex-ante fiscal mechanisms (e.g., stabilization funds), and stringent management of contingent liabilities, particularly from state-owned enterprises (SOEs). This note contributes to the debate by providing a systematic framework for understanding and modeling the distinct fiscal dynamics of SIDS, offering a more nuanced basis for policy intervention beyond traditional sovereign debt management.