Does Aid for Trade work for Small Vulnerable Economies?

4 April 2011

The discussions around Aid for Trade (AfT) tend to treat beneficiary countries as an homogeneous group of developing countries. However, a variety of important factors and needs specific to recipient countries should be considered in order to devise any effective AfT strategies. A group of developing countries largely neglected in the AfT discourse includes the small and vulnerable economies (SVEs), despite the special challenges these countries face in their integration into the global economy.

The rationale of AfT to SVEs

The group of SVEs includes the African, Caribbean, and Pacific small and island states. Due to their small populations, the domestic market is limited in these countries. As a result, most of the firms are small and medium enterprises with limited opportunities for reaping the benefits of economies of scale and investing in research and development. (1) Remoteness and isolation are typical features of SVEs which therefore suffer from high trading costs due to both small consignment size and high shipping costs. These high trading costs contribute in turn to a lack of competition and efficiency in the domestic economy, leading to higher cost of doing business. In a Commonwealth Secretariat study, Winters and Martins find that business costs, particularly transport and labour, are significantly higher in small states(2). In addition, most SVEs suffer from general developmental challenges such as poor investment climate, weak institutions, and inadequate human capital resources. These challenges are manifested in higher unit production costs, causing SVE exports to be uncompetitive in global markets.  Most SVE export baskets are highly concentrated on a few primary commodities exposed to high price volatility on the global market. The combined share of the two most important commodities/services is over 50 percent in the total exports of goods and services for most economies in the Pacific and Caribbean regions.

The competitive disadvantage of SVEs, arising largely from their inherent characteristics, is reflected in the trend of their marginalisation in world trade. During the sixty years between 1948 and 2008, the combined share of 39 selected SVEs in global merchandise export trade fell from 1.05% to 0.62%. Combined with commercial services, the share of SVEs without the oil-exporters has halved from 0.6% in 1980 to 0.3% in 2008. One of the main purposes of AfT is to promote supply response from developing countries and because nearly 70% of these countries have witnessed their relative significance in global trade dwindle, SVEs should be considered as important beneficiaries.

Another important rationale for AfT support arises from the need for trade-adjustment support. Studies have found that SVEs are extremely vulnerable to loss of trade preferences resulting from multilateral and regional trade liberalisation programmes. According to various estimates, about 15% - 29% of the total estimated loss of developing country exports due to preference erosion would come from SVEs. Considering that the share of population in SVEs is only about 2% of the total population of developing countries experiencing such losses, SVEs are expected to bear a much higher proportion of preference erosion costs. For certain countries like St Vincent and Grenadines, St Lucia, Dominica, and Sao Tome and Principe, the loss of exports due to preference erosion could be as high as 29% - 60% of their merchandise exports. These unusual country characteristics paired with potential trade shocks make SVEs' integration into the world economy a severely daunting task.

AfT flows to SVEs

Although there has been no specific aid programme for problems arising from inherent features associated with smallness and remoteness, SVEs have historically received higher levels of AfT per capita relative to other developing countries (Figure 1). This is consistent with the general aid pattern and this is mainly driven by these countries' small population. For example, a trade-related infrastructure project such as a bridge or an airport funded by AfT would cost a similar amount across countries. However, the AfT per capita of that same project would be considerably higher in a small than in a large receiving country.

What countries provide AfT to SVEs? The European Commission (EC) has been consistently the largest donor during 2002-07, with more than US$ 150 million disbursed in 2007, almost double the amount of 2006. Australia and Japan are the other major donors, with the former more than doubling its assistance in 2007. Other relatively large donors include France, Portugal, the US, Germany and the Netherlands.

The AfT spending distribution in SVEs across main categories is fairly similar to other developing countries as shown in Figure 2, with the largest share in economic infrastructures, followed by aid to productive sectors and aid to trade policy and regulations. The major difference lies in the less important aid to infrastructure in SVEs relative to non-SVEs; this type of AfT was three times larger than aid to productive sectors in 2006 although the ratio between these two types of AfT was just above the one for SVEs.

AfT effectiveness and SVEs

The existing evidence based on independent evaluations of specific trade related aid programmes on trade performance is mixed. This examination is challenging due to the difficulty in isolating the impact of AfT programmes on the recipients' economy, often resulting in a lack of clear and measurable objectives and indicators in programming documents. With that said, some problems in the programming and delivery of AfT become apparent. For example ACP countries' administrative constraints in dealing with EU procedures usually lead to very slow rates of aid disbursement, which may undermine the value of the assistance extended in support of time sensitive adjustment processes. A case in point is the EC Special Framework for Assistance (SFA) for bananas and rum, whose disbursement share in total allocation is below 30% for all beneficiary SVEs (3). Moreover, our review suggests the importance of ownership, alignment and harmonisation as critical factors of success of AfT, much in line with the traditional aid effectiveness literature. The implications mainly refer to the need to involve stakeholders, and trade and other officials in beneficiary countries from the very beginning - to help design programmes, devise specific objectives and implementation strategies, while keeping country-specific conditions in mind.

Lack of proper data and benchmarks has often constrained the possibility of properly assessing the effectiveness of AfT over a large number of projects. By using a large panel dataset of developing countries, in a study for the Commonwealth Secretariat, we provided more systematic and new evidence on AfT effectiveness and we examined the overall impact of different types of trade-related assistance on specific trade-performance indicators. The results need to be interpreted cautiously, as they are valid on average and may not be applicable to specific individual countries.

The key results suggest that a particular category of AfT, aid for trade facilitation, is likely to have had a significant cost-reducing effect on the costs of handling exports. SVEs seem to enjoy particularly high returns on aid for trade facilitation, up to three times larger than for other developing countries, which is consistent with these countries' higher average unit transaction costs on exports (as these are spread over smaller volumes of exports). The results further suggest that aid to economic infrastructure increases overall exports for developing countries, slightly more so for SVEs, although the difference between SVEs and other developing countries is not statistically significant. Aid to productive capacity has no significant effect on exports for either SVEs or non-SVEs, partly explained by a poor identification strategy. This type of aid is mostly sectoral and thus should be measured against sectoral exports. When we do use sectoral exports and sectoral aid for four broad sectors, heterogeneous effects of AfT across sectors are found. In particular, sectoral aid seems to have a positive impact on tourism and mineral exports, which is larger in SVEs than in non-SVEs, while food and manufacturing exports by SVEs do not appear to benefit from higher AfT.

Conclusions and policy suggestions

We have a number of general AfT-related suggestions for donors as well as for SVE policy-makers:

  • First, donors could consider introducing AfT programmes (or projects) addressing specific trade-related constraints faced by SVEs, particularly remoteness and isolation as these seem to be binding in a world of increased trade integration. These could include strengthening the trade-related infrastructure, both communications and transport, and the development of appropriate professional skills, especially for the services market where the disadvantages of remoteness and smallness are less severe.
  • Second, adjustment-related support within AfT has not been given much attention. However, such support could be extremely important for SVEs especially in the event of decisive progress in the multilateral trade liberalisation process.
  • Third, donors could consider scaling up the level of aid for trade facilitation as this appears to be a particularly cost-effective investment, especially in the case of SVEs.
  • Fourth, donors should improve the disbursement rules of AfT. Slow disbursement tends to undermine the value of the assistance extended in support of time sensitive adjustment processes, such as the trade-related ones experienced by SVEs.
  • Fifth, donors should work closely with recipients to identify contexts where more aid to productive sectors is needed. This form of aid seems to work better in certain SVE sectors, such as tourism and minerals.
  • Lastly further assessment of the sectoral aid allocation in production capacity is needed. The lack of export response to this type of aid could indicate ineffectiveness in traditional sectors. SVEs perhaps need to consider promoting sectors with dynamic comparative advantage to expand into manufacturing and other non-traditional activities to achieve diversification with the help of aid for trade.

Authors: Massimiliano Calì is Research Associate, Overseas Development Institute (ODI), London; Mohammad Razzaque is Economic Adviser, Economic Affairs Division, Commonwealth Secretariat, London; and Dirk Willem te Velde is Head of Programme, ODI, London. The article is based on a longer paper by the same authors titled "Effectiveness of Aid for Trade in Small and Vulnerable Economies: An Empirical Assessment", Economic Paper 91, Commonwealth Secretariat, London. The views expressed and limitations associated with the papers are the responsibility of the authors and not of the institutions to which they are affiliated.

1 For a more complete analysis of the challenges faced by small states, see Qureshi, M. and D.W. te Velde (2008), Working smart and small: The role of knowledge-based and service industries in growth strategies for small states, London: Stylus Publishing .

2 Winters, A. and P. M.G. Martins (2005). Beautiful but Costly: Business Costs in Small Remote Economies. London: Commonwealth Secretariat.

3 CTA (2008), The Experience of Agricultural Adjustment Programmes: Banana, Sugar and Internal EU Agricultural Reform, Brussels.

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