Productive capacity

Many vulnerabilities affect SIDS’ productive capacity

Fostering productive capacity and structural transformation for sustainable and inclusive growth and development is particularly important for SIDS1 as they are among the most vulnerable economies in the world. The new UNCTAD PCI2 measures the capacity of a country to produce goods and services, and sheds light on potential blockages and limitations, as well as opportunities for transformational growth. The PCI was developed at the request of -—
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request for input for UNDESA’s impact assessments and the Committee for Development Policy who assess countries' readiness for graduation from the LDC category.

Despite SIDS' high socioeconomic, climate change and other environmental vulnerabilities, some have achieved comparatively high levels of income per capita (e.g., the Bahamas, Nauru and Saint Kitts and Nevis), mainly thanks to the growth and expansion of services, particularly tourism services. In a few SIDS, agriculture and fisheries play an important role in driving growth and structural transformation (see Economic trends). We identify four types of vulnerabilities that underlie the analysis of productive capacities.

First, most SIDS have small economies, leaving little room for diversification in to manufacturing or agro-processing and the creation of economies of scale. Small and vulnerable economies face serious constraints in kickstarting secondary activities, such as manufacturing and agro-processing. As discussed in Sustainable industrialization, the average share of MVA in total value added for SIDS is far below the average for lower-middle income economies, and even below the level for LDCs. Most SIDS are dependent on agriculture, fisheries and services (typically tourism). However, a few SIDS are emerging as financial hubs or centers for business and financial services, with activities such as call centers, digital data production, or consumption and transfer centers (e.g., geo-localization technologies). The limited availability of land in SIDS often means that total factor productivity in agriculture is low, and land overuse can lead to environmental degradation and falling agricultural yields. Tourism, in turn, is affected by climate change, and other disasters and shocks, such as the COVID-19 pandemic. Small populations in most SIDS limit local labour supply and domestic demand. Against this background, structural transformation is likely to occur primarily through shifts to and transformation of the services sector.

Second, as discussed in Trade vulnerabilities, SIDS are highly dependent on international trade, especially importing manufactured goods, fossil fuels and often food. Many SIDS depend on the export of a limited number of agricultural commodities to only a few export destinations which renders them vulnerable to global price shocks and changes in demand for their products. SIDS have also been adversely affected by the gradual erosion of trade preferences for some of their primary export products, such as bananas and sugar. They have had negative merchandise trade balances for the past 15 years, the relative size of which has increased recently (see Trade vulnerabilities). Moreover, due to their remoteness, SIDS experience high trade costs linked to limited shipping services to their markets, and some depend on air transport. Goods often incur high storage and insurance costs prior to shipping, and the limited number of shipping providers to some SIDS creates risks of oligopolistic pricing behavior -—
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. The geographic isolation of SIDS also leads to high communications costs, limiting the potential of these countries as ICT hubs.

Third, SIDS are some of the most disaster-prone countries in the world -—
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, and are vulnerable to tropical cyclones, hurricanes, earthquakes, tsunamis, etc. As discussed in Environment, disasters can cause significant losses of human life and damage to the economic infrastructure in SIDS. According to some estimates, the 2004 tsunami caused damage to the Maldives economy the equivalent of 62 per cent of its annual GDP -—
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. With climate change, the frequency and intensity of tropical cyclones, typhoons and hurricanes has increased. The long-run-effects of natural disasters and climate change could lead to significant loss of coastal land and environmental degradation in many SIDS, and in some cases threaten their very existence. Climate change and the overuse of scarce natural resources, such as land, can adversely impact soil quality, agricultural productivity and the quality of freshwater and marine resources, which are already stretched to their limits in many cases. Furthermore, SIDS are often rich in biodiversity, strengthening the need for cautious environmental management to sustainably harness these valuable resources. Finally, as economies that are often highly dependent on fishery and tourism, the environmental degradation of the oceans, including through over-fishing, pollution and coral bleaching, is an additional source of vulnerability. Some SIDS also suffer from limited private and public institutional capacity and poorly developed infrastructure, which exacerbates the impact of adverse shocks and reduces socioeconomic resilience (see Environment).

As a result of the above vulnerabilities, SIDS’ GDP growth is more volatile than that of other developing countries. The largest downturn before 2020 was seen during the 2008-2009 global financial and economic crisis, when the average annual GDP growth rate declined from above 8 per cent in 2006 to -3.5 per cent in 2009 (see Economic trends).

Despite the numerous challenges, systemic risks and vulnerabilities outlined above, SIDS are characterized by relatively high average HDI scores -—
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(see Country profiles)(figure 1). SIDS showed an increase in mean HDI values from 0.65 in 2000 to 0.75 in 2018, thereby reaching higher levels than the LDCs’ average of 0.4 and 0.5, over the same period, and converging towards those of developed economies (0.85 and 0.9). Productive capacities played an important role in SIDS achieving this encouraging development, as the analysis of the PCI below will show.

Figure 1. Human development in SIDS, LDCs and developed economies Figure 1. Human development in SIDS, LDCs and developed economies
(Regional average HDI score)
Source: UNCTAD calculations based on -—
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Note: No HDI for Nauru and Tuvalu.

SIDS' productive capacity is correlated with human development

It is striking, firstly, that productive capacities are highly correlated with the HDI among SIDS. This is the case even when the PCI's human capital component, which has much in common with the knowledge dimension of the HDI, is not included. In 2018, the two indices were highly positively correlated (ρ = 0.94). SIDS with lower productive capacities were those with lower human development scores, and those with higher productive capacities featured in the top ranks of human development.

Figure 2. SIDS’ HDI and PCI excluding human capital, 2018 Figure 2. SIDS’ HDI and PCI excluding human capital, 2018
(HDI and PCI scores and their correlation)
Source: UNCTAD calculations based on -—
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Note: Geometric mean of PCI scores for all other components than human capital.

As with the HDI, SIDS perform better than other structurally vulnerable economies with regard to productive capacities. Figure 3 shows that, among LDCs, SIDS are strongly over-represented in the classes with a PCI of 25 or higher. Only one SIDS, the Comoros, had a PCI score of less than 25 in 2018, while most other LDCs fell short of that level. Furthermore, SIDS not classified as LDCs never had a PCI of less than 30, whereas this was the case for all except two LDCs, namely Tuvalu and Bhutan. In other words, a fairly clear cut-off line between non-LDC SIDS and LDCs can be drawn at a PCI score of 30. SIDS also appear to be more strongly represented in higher PCI classes than LLDCs. However, this difference in performance seems less pronounced than the difference with LDCs.

Figure 3. Productive capacities, by development status, 2018 Figure 3. Productive capacities, by development status, 2018
(PCI score)
Source: UNCTAD calculations based on -—
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SIDS have achieved higher levels of human development than many LDCs, despite their particular vulnerabilities, outlined above. What role have their productive capacities played? The main indicator of human development in the HDI, other than human capital and health, is GDP per capita. The choice of this aggregate measure of income is grounded on the rationale that income represents an important resource for increasing people's capabilities "to pursue the choices that they value" -—
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, thus expanding their freedom. Productive capacities play an important role in promoting the generation of income.

Structural transformation has moved focus towards services

The distribution of economic activity over sectors is an important dimension of productive capacity, considering productivity differences of sectors. Agriculture, including forestry and fishing, for example, is generally characterized by relatively low value added per worker. Its output is highly dependent on weather conditions and can strongly fluctuate over time, especially in SIDS, which are more exposed to winds and floods than other economies in the tropics. Relying largely on agriculture, therefore, usually renders stable income generation difficult. SIDS’ share of agriculture (including hunting, forestry and fishing) in GDP decreased from almost 10 per cent in 1970 to around 5 per cent by 2018. In 1970, it was around one fourth of GDP in Atlantic and Indian Ocean as well as in Pacific SIDS. Transformation over time has been especially pronounced in Atlantic and Indian Ocean SIDS, where the agriculture share fell to 6 per cent of GDP until 2018, whereas in Pacific SIDS it was still at 15 per in 2018 cent -—
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Figure 4 confirms that SIDS still relying heavily on agriculture are those where GDP per capita is relatively low. In 2018, the share of agriculture in GDP was negatively correlated (ρ = -0.80) with GDP per capita (in logarithms).

Figure 4. Share of agriculture in GDP and GDP per capita, 2018 Figure 4. Share of agriculture in GDP and GDP per capita, 2018
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Note: Agriculture includes hunting, forestry and fishing (ISIC Rev. 3 sections A and B, see -—
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).

As the share of agriculture in GDP has dwindled over the last decades, the dependence on exports of food and agricultural raw materials has been replaced by services and other exports, often associated with more skilled and knowledge-intensive activities. The share of services in SIDS’ GDP has increased from 62 per cent in 1970 to about 70 per cent in 2018, as described in Economic trends. Studies by -—
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find that the high employment intensity of the services sector, and of tourism in particular, are important sources of economic growth. It is noteworthy that the share of the 'other service activities' (ISIC *Rev. 3 sections J to P), i.e., services not primarily related to construction, distribution of goods or tourism, has increased from about 32 per cent in 1970 to 38 per cent in 2018 -—
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. This is also reflected in the development of SIDS’ services exports, discussed in Trade in services.

Figure 5 confirms that SIDS with a relatively high GDP share of 'other service activities' tend to achieve a higher GDP per capita than others. SIDS with 'other service activities' as a vital sector are mainly Caribbean, for example Bahamas, Grenada, Barbados, and Saint Vincent and the Grenadines, but also Tuvalu, Mauritius, Palau, Marshall Islands and Kiribati. In contrast, SIDS with the lowest share of 'other service activities' are mostly located in the Pacific, with the exception of Trinidad and Tobago which is a primarily oil producing economy.

Figure 5. Share of 'other service activities' in GDP and GDP per capita, 2018 Figure 5. Share of 'other service activities' in GDP and GDP per capita, 2018
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SIDS’ servitization is driven by strong institutions and ICT

Human capital is the PCI component that is most positively correlated with two service sectors: 'trade, hotels and restaurants' and the 'other service activities' (see table 1). High education of the workforce and investment in research and development can be crucial for the development of services. New Growth Theories also note that once a vital sector has been established, this can promote spillover effects, further increasing the stock of human capital -—
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show how SIDS’ tourism sector can be transformed into high-value and high-end tourism services through intersectoral knowledge spillovers, technological innovation and improved environmental sustainability.

Table 1. Correlation of PCI components with shares of selected sectors in GDP
(Correlation coefficients)
PCI componentShare in GDP
Agriculture
(ISIC A-B)
Trade, hotels, restaurants
(ISIC G-H)
'Other' services
(ISIC J-P)
Energy-0.370.030.00
Human capital-0.630.240.35
ICT-0.780.120.50
Institutions-0.64-0.040.53
Natural capital0.54-0.28-0.24
Private sector0.02-0.330.44
Structural change-0.620.180.16
Transport-0.340.120.42
All-0.760.090.50
Source: UNCTAD calculations based on -—
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Note: Antigua and Barbuda, Nauru, Federated States of Micronesia and Saint Kitts and Nevis not included due to missing data.

The table also indicates that the development of 'other service activities', not trade, hotels and restaurants, relies on productive capacities associated with institutions, ICT, the private sector and transport. These capacities turn out to be even more important than human capital for 'other service activities'. It appears that efficient rules and procedures, political stability, a safe and democratic environment, a well-developed infrastructure for communication, information exchange and transport of people and goods, as well as a favourable environment for doing business are important for the emergence of 'other service activities'. The important role of institutions for productive economic activity are well known from Institutional Economics. Properly functioning institutions can help save transaction costs, as they facilitate overall compliance with agreed rules, thereby reducing coordination and monitoring costs, incentives for free-rider behaviour and moral hazard -—
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Not surprisingly, table 1 also shows that productive capacities related to natural capital promote agricultural rather than other activities. This implies a negative impact on the relative importance of other economic sectors, including services.

Finally, the correlation of the structural change component of the PCI and the two service sectors’ shares in GDP is strikingly weak. This can be taken as evidence for the SIDS' atypical path of sectoral transformation (see Sustainable industry). Productive capacity for structural change is evaluated in the PCI based on export concentration, economic complexity, gross fixed capital formation and the share of industry and services in total GDP. In SIDS, however, the transformation of agriculture into higher productivity activities does not seem to be strongly driven by large-scale formation of fixed capital and expansion of manufacturing. This is largely due to constraints arising from paucity of land, limited labour supply, scarcity of physical production factors and distance from markets. Tourism and the vast oceans economy, however, provide SIDS with prospects for a direct structural transformation to higher value-added activities in the service sector, not led by the development of an 'industrial core'. (see Economic trends, Tourism and Trade in Services). The observed “servitization” of SIDS’ economies, not led by manufacturing, appears thus consistent with their comparative advantage.

As shown by figure 6, Bahamas, Barbados, Palau, Mauritius, Saint Vincent and the Grenadines, and to some extent Seychelles, have strong productive capacities arising from efficient institutions, private sector development, ICT and/or transport infrastructure which have promoted the emergence of a relatively large 'other service activities' sector. A closer look reveals that the main strengths of Tuvalu and Mauritius are in private sector development, whereas the other aforementioned SIDS rely more on strong institutions, efficient ICT and transport networks -—
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. Trinidad and Tobago is a notable exception; despite high scores in those PCI dimensions, 'other service activities' do not account for a large share of economic activity, apparently overshadowed by the extraction of fuels. Kiribati and the Marshall Islands developed a comparatively large 'other service activities' sector although their PCI scores for institutions, ICT, private sector and transport are not particularly high. The overall pattern presented in the figure, however, confirms the positive relation between those types of productive capacities and the share of 'other service activities' in GDP.

Figure 6. Productive capacities in institutions, ICT, private sector and transport and the share of 'other' services in GDP, 2018 Figure 6. Productive capacities in institutions, ICT, private sector and transport and the share of 'other' services in GDP, 2018
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Note: Geometric mean of PCI scores for institutions, ICT, private sector and transport.

Figure 7 illustrates how the productive capacity of human capital is related to the share of ‘trade, hotels and restaurants’ in GDP. Maldives provides an example where a relatively large ‘trade, hotels and restaurants’ sector goes hand in hand with a highly skilled workforce and/or an advanced educational infrastructure. In Tuvalu, by contrast, both aspects were relatively poorly developed in 2018. Several Caribbean SIDS, such as Saint Lucia, Barbados and the Bahamas, combine a relatively high share of ‘trade, hotels and restaurants’ in the economy with higher-than-average PCI scores in human capital. Only in Samoa, Sao Tome and Principe, and Palau was the high share of economic activity in trade, hotels and restaurants achieved without particularly high human capital. In Vanuatu, Solomon Islands and Comoros, human capital seems relatively low compared to other SIDS with a similar share of ‘trade, hotels and restaurants’.

Figure 7. Productive capacities in human capital and the share of trade, hotels and restaurants in GDP, 2018 Figure 7. Productive capacities in human capital and the share of trade, hotels and restaurants in GDP, 2018
Source: UNCTAD calculations based on data from -—
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Note: Trade, hotels and restaurants include ISIC Rev. 3 sections G and H.

How to develop productive capacities in SIDS?

The analysis shows that in SIDS productive capacities are highly correlated with human development. GDP per capita is highest in SIDS which have succeeded in transforming from agriculture to service activities. Productive capacities, especially those related to human capital, institutions, private sector, ICT and transport, play an important role in that structural transformation to services (see figure 8). Human capital has, firstly, a direct effect on human development, as it increases people's capability to acquire knowledge, and, secondly, an indirect effect, as it increases SIDS’ economic capacity to develop a vital services sector. These vital sectors include 'trade, hotels and restaurants' and 'other service activities'. The latter comprise financial intermediation, business services, health services, public administration etc.

Figure 8. Linkages between productive capacities, servitization and human development Figure 8. Linkages between productive capacities, servitization and human development

Source: UNCTAD deliberations.

Highly productive (service) activities enable the generation of more income per worker than less productive activities, often found in agriculture. Thus, an expansion of those activities bears high potential for increasing GDP per capita. Growing GDP per capita levels, in turn, increase people's capabilities, thereby expanding their freedoms and advancing human development.

Capacity development targeting the promotion of structural transformation in SIDS must take into account their particular circumstances resulting from the small size of their economies, their remoteness from larger markets and their climatic conditions. Large-scale industrialization and high investments into machinery do not seem to play the same prominent role as they did in the structural transformation observed in Western Europe, Northern America and developed economies in other regions. In SIDS, servitization is almost uncorrelated with the structural change component of the PCI; productive capacities related to human capital, institutions, ICT, private sector and transport seem to be more important.

Based on these considerations, successful strategies to promote structural transformation in SIDS can be built on two pillars:

  • Identifying activities that make best use of SIDS’ specific comparative advantages, where service activities, in particular tourism and other service activities, currently play an important role, due to the SIDS geographic and climatic conditions,
  • Enhancing productive capacities, in support of the identified comparative advantages, with a focus on the development of an efficient institutional framework, favourable conditions for doing business, high-quality, robust and viable ICT networks and an efficient transport infrastructure, as well as schools, training centers, research institutes and universities to foster human capital.

The UNCTAD PCI is multidimensional and, as such, captures key drivers and enablers of growth and development. An analysis of its categories, with related statistics, provides a pragmatic tool for evidence-informed policy and an instrument to strengthen countries' productive capacity to progress towards the SDGs. The full application of the PCI in SIDS calls for strengthened development partnerships, particularly to address the SIDS' structural vulnerabilities (see What makes a SIDS a SIDS?).

Some conclusions emerge form the above analysis. First, despite their vulnerabilities, the productive capacity of SIDS is far better than that of LDCs and LLDCs, and this is reflected in higher levels of human development. Second, given their small size, paucity of labour, disconnectedness from factor and sales markets, on the one hand, and their rich ocean economy and their attractiveness as tourist destinations on the other, the SIDS' virtue lies in the development of services, especially tourism, and does not require the development of a large manufacturing sector as a precursor. As mentioned, servitization has enabled SIDS to achieve relatively high levels of GDP per capita, an important resource for human development. Third, productive capacities in human capital, institutions, ICT, private sector and transport are important drivers of servitization in SIDS. All in all, it appears that “size is not a significantly important determining factor for economcic growth or GDP per capita”, supporting the principal thesis proposed by -—
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. The PCI provides a fresh approach to examing the potential and prospects for SIDS to develop their productive capacity independently of their small size and distance from markets.

Notes
  1. Fostering productive capacities and structural economic transformation for sustainable and inclusive growth and development has been intensely debated in recent major international conferences, such as the Fourth United Nations Conference on LDCs held in Istanbul, Turkey in May 2011, the Second United Nations Conference on Landlocked Developing Countries held in Vienna, Austria in November 2014, and the Fourteenth United Nations Conference on Trade and Development (UNCTAD XIV) held in Nairobi, Kenya in July 2016.
  2. The PCI was developed by -—
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    at the request of member States and covers 193 economies for the initial period from 2000 to 2018. The aim of the index is to improve the quality of trade and development policies by placing the fostering of productive capacities and structural economic transformation at the centre. The index helps identify economy-wide gaps and limitations that hinder efforts aimed at fostering productive capacities and structural economic transformation in developing countries. Information on the statistical techniques and methodology used in developing the PCI, including the list of indicators and data sources, as well as the complete scores for 193 economies, together with related analytical papers, reports and an operational manual, is available at https://pci.unctad.org. The data are available in -—
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    and information on the concepts and methods in -—
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References
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