# **1. Introduction**

The pandemic and subsequent global shocks hit small states—those with a population of around 1.5 million or less—particularly hard (World Bank 2023a). Small states experienced some of the deepest contractions and slowest recoveries of all emerging markets and developing economies (EMDEs). Governments appropriately implemented wide-ranging and often large spending measures to support firms and households. These, together with weaker revenue, led to a substantial widening of fiscal deficits, adding to already high and rising levels of public debt.

These developments are especially troubling against the backdrop of significant longstanding development and fiscal policy challenges (figure 1; World Bank 2023a). Since 2000, annual growth of GDP per capita in small states has on average been 2.6 percentage points slower than in other EMDEs and barely kept pace with advanced economies. Recent fiscal consolidation efforts have helped narrow deficits in some cases. Yet in many small states fiscal positions remain precarious, increasing risks to fiscal sustainability. This paper therefore examines fiscal policy challenges in the context of developments before and since the onset of the pandemic.

Small states, located in every World Bank region of the world and with sometimes large exclusive economic zones that span vast areas of the world’s oceans, are highly heterogeneous, comprising a mix of high- and middle-income countries as well as some fragile and conflict-affected situations (table 1). However, the fiscal challenges they face reflect important common underlying vulnerabilities that raise their exposure to adverse exogenous shocks (UNCTAD 2022; World Bank 2023a). Trade openness is much higher in small states than other EMDEs, while economic activity, including exports, is highly concentrated in a few sectors of comparative advantage. High openness and lack of diversification leave the fortunes of small state economies dependent on developments in key sectors—notably tourism and some commodity sectors—resulting in higher output volatility than in other EMDEs (Briguglio and Vella 2018).

The experience of small states during the pandemic underscores their structural vulnerabilities. Tourism, which accounts for higher shares of economic activity and export earnings than in other EMDEs, was devastated. Some small states, moreover, rely heavily on exports of a narrow range of commodities such as oil and gas, the prices of which plummeted in 2020. Many small states also rely on remittances for much of their external income, but these were severely affected by pandemic-related restrictions on international labor mobility and the decline in demand for labor in host economies. Advanced economies and many EMDEs experienced robust recoveries as the global recovery took hold. For small states, however, the economic and fiscal consequences have endured.

Many small states are tropical islands, which are highly vulnerable to costly natural disasters, particularly storms and other weather-related events that have become more frequent with climate change (Fornino et al. 2024; Heinen, Khadan, and Strobl 2019). As a result, small states face substantial climate change adaptation challenges that are compounded by a lack of resources to invest in resilient infrastructure (Jafino et al. 2020; UNEP 2023; World Bank forthcoming). Small states also face the risk of a sustained deterioration in productive capacity. Some of them face 2