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Global macro & geopolitics from a small economy perspective

No country is an island

David Skilling
25 May 2012

In a more volatile, less ordered global environment, it will become increasingly difficult for countries, particularly small countries, to act independently and simply take advantage of an open, global order. To an increasing extent small countries will need to integrate themselves into groupings and networks. So this week’s Observer considers the need for small countries to secure opportunities and manage risks by deliberately building a structured portfolio of external relationships.

Safety in numbers
Small countries have been major beneficiaries of the rules-based, multilateral system that has existed for the last 60 years, which has enabled countries to expand beyond their domestic markets. Although politics still mattered (not all relationships were equal) and there was a regional bias to international economic activity, this meant that, combined with reasonable geopolitical stability, thinking about the portfolio of international relationships was relatively straightforward. Aside from issues like the risk profile of export markets and security of supply of key inputs like oil, most advanced economies have been able to rely on markets and liberal rules. Geneva and New York (and Brussels) were a key focus of action.

But in a changing world, new approaches are needed. The world is less ordered (the G-Zero), the multilateral system has less influence relative to large countries and new groupings, and economic and political turbulence is increasing. Small states have performed relatively well over the past couple of decades because they have adapted well to the changing environment. But in this emerging world, one of the key requirements for ongoing strong performance is deliberately building a portfolio of relationships to address issues like market access, security of supply, and managing economic and market volatility. Small countries can continue to perform, if they are thoughtfully integrated into networks and relationships, but being small and independent in a turbulent, disordered world is likely to be a very uncomfortable place. Alliances can clearly entangle, but they also protect against risk and provide opportunities. Small states (and indeed, many larger countries) need to carefully balance these considerations. No country is an island.

From commercial diplomacy to economic statecraft
So just as there is no such thing as domestic policy in the latest phase of globalisation – all policies need to be informed a clear view of the global environment – so too an increasingly important part of economic policy is how countries position themselves externally in the global economy. For small countries, the effectiveness of economic strategy is tightly linked to the nature of the country’s portfolio of external relationships. Even a strong competitive strategy may not be robust to external developments such as a change in market access, the cost of capital, or economic shocks (as we see currently in Europe). In response, governments need to supplement conventional commercial diplomacy – negotiating FTAs, and promoting exports and investment – with action on relationships structured around various other important economic issues, such as capital account and exchange rate arrangements, energy and food security, research collaboration, and labour market and immigration policy. There is increasing activity in this space, often with small states in the vanguard; from regional and bilateral FTAs, to currency swaps arrangements, to food security deals.

For many small countries, the issue is to find ‘artificial’ ways of bulking up on these dimensions to increase resilience and access opportunity without losing too much sovereignty and some of the advantages of small size (flexibility, agility, shared purpose). This broader canvas of issues makes a structured approach to building a portfolio of external relationships much more important – and challenging – than has historically been the case. Governments need to develop a perspective on how different relationships contribute to reducing or increasing various risks and opportunities, and how these can be packaged together. Will more formal regional integration reduce or create strategic exposure, how much economic exposure should we have to China and other emerging markets, are our exchange rate arrangements a buffer or a source of exposure, and so on. For small countries, these strategic choices will likely have a first-order impact on performance. There is also a geographic dimension. For many small countries, there has been an obvious regional answer to developing relationships (e.g. the EU or ASEAN). Regionalism will continue to be a powerful force, but there are some issues where out-of-region relationships will become more important (e.g. to provide diversification).

Political economy is back
Another way of stating the above is that politics and economics are increasingly intertwined. Economics is driving politics, and vice versa. This means that the way in which international economic relationships are developed needs to be informed by political and strategic considerations as well as economic consideration. Indeed, one key challenge faced by many countries is how to balance rapidly growing economic relationships with traditional political and security relationships. In such a world, foreign policy is a vital part of an effective economic strategy (and vice versa). Big power politics is a confronting reality for small states, but the flexibility of small states may enable them to respond tolerably well through a creative, flexible approach to external strategy. Indeed, I expect we will see a more fluid environment with small states embedded in multiple networks, including some with sub-national units.

Governments will need to think in a structured way about how to navigate this emerging world. Among other things, this likely means a tight relationship between economic and foreign policy to ensure consistency of direction. And economic agencies and foreign policy ministries need to develop the capacity to support this. Foreign ministries need an awareness of economic strategy and forces, both at home and abroad, and economic agencies need to be thoughtful about the strategic landscape and to have a deep knowledge of global issues. Overall, governments need to develop the capacity for a thoughtful, deliberate approach to the way in which global engagement is undertaken. Governments that respond to the reality that no country is an island, and deliberately build an appropriate portfolio of relationships, will do better than those that do not adapt to this changed global context.