Pillars of very small economies

Contrary to the widely held belief that VSC economies mainly rely on financial services and even on illegal activities like money laundering, we found that the economic sources of success are much more diverse in reality. Especially the high-income VSC are much more on-shore than off-shore economies. Due to this diversity, it is not easy to find a com-mon denominator for the success stories. Judging from the case studies in Section 5.2, we are however able to obtain some hints as to the best economic strategies for a VSC, bearing in mind a few caveats already mentioned above.

Needless to say, the first advice would be to exploit natural resour-ces if any are existent. It also goes without saying that VSC have to take a closer look at sustainability than larger countries due to their limited size and the vulnerability of their ecosystems. Brunei and Iceland are two excellent examples of VSC with valuable natural resources. Their economic structure clearly reflects the existence of these resources, and they are well adapted to their specific economic situation, which is, of course, a key to economic success. Other resource-abundant VSC are less successful, like, e.g., Nauru, where phosphates are mined. Note how ever that Nauru is one of the high-income VSC in the Pacific re gion and its disadvantage may be, to a considerable extent, driven by its re-moteness.

In connection with natural resources, we have to consider natural resources that are not quarried and not mined. Many VSC and especial-ly island VSC have beautiful landscapes and, therefore, a flourishing tour ism industry. Again, a word on sustainability is in order. Given its dependence on tourism, island VSC in the Caribbean run the risk of destroying their natural heritage if the number of tourists continues to inercase. Tourism is a perfect source of welfare for VSC because it com -p lies with the s-pecific advantages of many VSC and it also creates jobs for less-educated citizens. Almost all VSC have a tourism sector of con-siderable size; some are even highly dependent on tourists. The Bahamas are a good example of this. Note however that there is no apparent difference with regard to the size of the tourism sector between high income and low-income VSC. Not unexpectedly, Pacific VSC seem to do worse despite of almost paradise-like landscapes. The problem of attracting enough tourists may, again, be attributed to their remoteness.

The service sector, and especially the financial service sector, has proven to be the single most important source of welfare for most VSC.

In contrast to the exploitation of natural resources and to tourism – nei -ther of require a great degree of autonomy – law-making authority and a considerable scope of sovereign action are prerequisites for a specia-lization in financial services. Hence, the promotion of the financial ser-vices sector seems to concern the core of relevant sovereignty for VSC.

The interaction of size and specialization in financial services should make it possible to some conclusions on the necessary kind and extent of law-making authority, which will be at the heart of our examination in the following sections. In any case, financial services, banking and re-lated services are a major source of revenue for almost all VSC. It cannot be a coincidence that so many VSC have specialized in these branches.

One reason for this fact might be that VSC can overcome disadvan -t ages of remo-teness and high -transpor-ta-tion cos-t by specializing in servi-ces, which often only require data networks and means of telecommuni-cation. No other possible economic activity is more independent of geo-graphic distance than distinct services and, above all, financial services.

Note that the internet has been opening up new possibilities for remote VSC by establishing quite a few branches which are also associated with low transport costs: internet services, internet retailing or software de-velopment are examples. There are some signs that VSC are aware of these new possibilities, but they have not proceeded far in terms of

estab lishing such enterprises to a large extent. The lack of an appropri -ate infrastructure and well-trained computer experts, especially when re-mote island VSC are concerned, may be two promising explanations for the slow development in these areas.

It is however astonishing that the existence of a strong financial ser-vice sector is a bad deser-vice to distinguish between high-income and low-income VSC. In other words, many VSC try to specialize in financial services, but only a few are truly successful. This means that a specia-lization in financial services and banking may result in high levels of wel-fare, but it is far from guaranteeing high income. One therefore has to be cautious in advising less developed VSC to promote only the financial service sector and to follow strategies which are solely tailored to the needs of this sector.

It is even more surprising that those countries which are on the above-mentioned FATF-GAFI list and therefore suspected of not com-bating money laundering adequately are far from being the ones with the highest per capita GDP. Seven of the 17 countries listed by FATF-GAFI (2001) are VSC or SAR, none of them are among the selected eight high-income VSC, and some have even been disregarded in our set of 21 due to their low GDP per capita.¹²⁷ The removal of the Bahamas, the Cayman Islands and Liechtenstein in June 2000 is a clear indication that these countries put in a lot of political effort in addressing the deficien-cies identified by the FATF through the enactment of legal reforms. This proves that high-income VSC are very much concerned about their in-ternational reputation. A listing by the FATF would not comply with their image of a safe and reputable place for financial services, based on a rather long tradition and on credibility. Advising a low-income VSC to develop the financial service sector would, if done at all, include a remark on the importance of confidentiality and compliance with international rules. Note however that there are a remarkable number of VSC on the OECD list of harmful tax practices. This list reads like the «Who’s who»

of VSC and clearly shows the specialization of many VSC.¹²⁸

127 Listed are the following VSC and SAR: Cook Islands, Dominica, Marshall Islands, Nauru, Niue, St. Kitts and Nevis, St. Vincent and the Grenadines. In June 2000 the Bahamas, the Cayman Islands and Liechtenstein were removed.

128 33 of 37 countries listed are VSC or SAR according to the definition used in this study.

Trade openness and individual freedom as well as democracy have proven to be a condition for VSC success. The only high-income VSC without a democratic system is Brunei¹²⁹, where the lack of democracy is not so important in economic terms, because the extraction and re -finement of oil and natural gas may also be organized and/or strictly controlled by the government or by government agencies. The climate of personal freedom is much more important when the service sector is concerned. High vulnerability and high transport costs are obviously det rimental to economic success in VSC. This finding is not surprising and establishes a natural disadvantage result for small island economies, especially in the Pacific region.

Another word on openness is in order. When we apply the term ge-nerally, it implies not only trade openness, but also compliance with the rules of international and regional organizations. It is obvious that VSC policies with regard to openness are ambiguous, meandering between a high level of trade openness to overcome the disadvantages of the small home market and some protectionist measures to support their niche strategies as firmly as possible. It is a revealing fact that very few VSC are full members of supranational organizations. Even though there are often comprehensive treaties with these organizations, full membership would probably endanger the VSC strategies to promote niche activities.

It is therefore a common misunderstanding that high-income VSC are very open. They try to abolish trade restrictions with adjacent coun-tries, as long as their core industries are not concerned. With regard to this strategy they do not differ from many larger countries. As soon as a VSC’s economic niches are concerned, protectionist measures are widely used and the necessary sovereignty is defended vigorously. Free mov e ment of people and the right to establish enterprises without being a citizen is therefore often a problem for VSC.

Liechtenstein, e.g., had major objections to these freedoms in the EEA because the heart of its service sector was concerned, but exemp -tions and interim regula-tions led to the accession of Liechtenstein. Note that it has been shown meanwhile that the effects of the freedom of mo-vement have not been detrimental to the Liechtenstein economy.

129 In Liechtenstein there is an ongoing constitutional debate on the political influence of the prince.

Another example would be the reluctance of Luxembourg to give up its strict confidentiality rules in banking in order to enable other EU mem-ber countries to tax citizens who shift their money to Luxembourg.

VSC obviously follow a two-fold strategy:

– They defend those parts of sovereignty which are a prerequisite for promoting and protecting their niche strategies.

– They try to protect their key industries and services by many mea-sures, which may be restrictions in trade, but may also be the reluc-tance to comply with rules of international organizations if they en-danger their economic niches.

Note that the extent of the necessary sovereignty is rather small. It first and foremost includes an independent law-making authority which might even be restricted to areas where niche strategies are located. The next two sections are designed to shed more light on the question of the necessary sovereignty.