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Nicaragua: Selected Issues

Author(s):
International Monetary Fund. Western Hemisphere Dept.
Published Date:
June 2017
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Nicaragua: Macroeconomic Impact of Climate Change and Disasters1,2

He who has no anxious thoughts for the future will find trouble right at hand.

−-Chinese Proverb

1. Nicaragua is highly vulnerable to the significant economic and social costs of climate change and disasters (CCDs). CCDs’ risks are disproportionate to Nicaragua’s size, population and the emission of greenhouse gases (Table 1). High exposure to both types of risk compounds the total macroeconomic impact, as they are mutually reinforcing.3 The authorities are aware and have taken measures to adapt and mitigate these risks. This paper reviews the current estimates on the potential impact of climate change on countries of initial temperature and income level similar to those of Nicaragua. It also estimates the macroeconomic impact of disaster events on Nicaragua. Based on the estimates, the paper discusses policy implications.

Table 1.Exposure to Natural Disasters
NicaraguaWorldNicaragua’s Share in percent
Number of Natural Disasters (1950–2016)7814,1450.55
Greenhouse Gas Emissions (2013) (metric tons of CO2 equivalent)1448,2570.03
Population (million)67,1760.08
Land Area (million Km2)0.121300.09
Source: EM-DAT, World Resource Institute, the World Bank and staff calculation.
Source: EM-DAT, World Resource Institute, the World Bank and staff calculation.

A. Macroeconomic Impact of Climate Change

2. The impact of climate change on the global economy is expected to intensify over the coming decades. Mean projected warming in the absence of mitigation is expected to reach about 3 to 4 degrees Celsius (°C) by 2100.1 Temperature increase and related risks2 are estimated to translate into output losses through the impact on climate-sensitive sectors such as agriculture, forestry, coastal real estate, and tourism. Other impacts include ecosystem disruption, infrastructure deterioration, health damages, and water stress. Tol (2009 and 2014) reviewed 21 studies on the global economic impact of climate change, which estimated the increase in temperature between 1 and 5.4 °C.3 The impact on GDP growth is estimated in a range between −11.5 and 2.3 percentage points (Figure 1). Although there is considerable variation across studies, the average impact from a 3°C increase in temperate is projected at about −2 percent of global GDP by 2100.

Figure 1.21 Estimates of the Global Economic Impact of Climate Change

Source: Tol (2014)

3. Climate change is expected to have greater impact for countries with higher initial temperatures and low income. Based on economic production data for 166 countries over the period of 1960–2010, Burke, Hsiang and Miguel (2015) find that countries’ productivity react differently to climate change depending on their initial temperature. Cold countries’ (with annual average temperature below 13°C) productivity would increase as annual temperature increases whereas countries with average temperature above 13°C, productivity would decline with global warming (Figure 2). The marginal impact of increasing the average temperature by 1 °C for a country with average initial temperature of about 25°C, such as Nicaragua, would be a reduction of about 1 percent in productivity growth. Dell, Jones and Olken (2012) find a relationship between initial income and impact of climate change. In poor countries, one-degree rise in temperature in a given period reduces economic growth by about 1.3 percentage points on average, whereas there is effectively no effect on rich countries (Table 2).

Figure 2.Marginal Reaction of Productivity to Change in Temperature Depending on the Initial Temperature

Source: Burke, Hslang ana Miguel (2015)

Blue dots (point estimate) and lines (95 percent confidence internal) shows marginal effects of temperature on growth evaluated at different average temperature Orange dots and lines shows equivalent estimates But controlled by GDP

Table 2.Immediate – Effect-of-Change-in-Temperature*
GDP GrowthGrowth in Agriculture Value-addedGrowth in industrial value added
Poor countries−1.374**

(0.408)
−2 666**

(0.948)
−2.036**

(0.878)
Rich countries0.262

(0.311)
−0.222

(0.650)
0.514

(0.452)
Source: Dell, Jones and Qken (2012)*** Significant at 1 percent level; ** Significant at the 5 percent level.
Source: Dell, Jones and Qken (2012)*** Significant at 1 percent level; ** Significant at the 5 percent level.

4. The impact of climate change on production is expected to be broad-based and particularly large on the agricultural sector. Dell, Jones and Olken (2012) find that, for poor countries, one-degree rise in temperature is associated with 2.66 percentage points lower growth in agricultural output, and 2.04 percentage points lower growth in industrial output. Exposure to climate change and related extreme weather events would also affect some service sectors such as tourism.

5. Average temperature in Nicaragua has already increased by about 1°C since 1950 (Figure 3). This increase is broadly in line with the global warming pattern. Further increase in temperature and related changes are expected to impact negatively GDP growth, mainly by reducing agricultural output; rising sea level and affecting coastal areas; degrading the environment and deteriorating health.1 At the same time, changing weather patterns could disrupt traditional business models and lead to dislocation of economic activities. In addition to the damage from climate change, the need to implement adaptation measures will weigh on the budget.

Figure 3.Average Temperature

(Population weighted)

Source: University of Delaware Air Temperature & Precipitation.

6. Nicaragua has limited possibilities to mitigate climate change. The authorities estimate that Nicaragua’s carbon footprint is very low. Nicaragua’s greenhouse gas emission amounted to 14.3 metric tons of CO2 equivalent in 2013, accounting for 0.03 percent of the world total. As a comparison, the emission of the major advanced and emerging economies is shown in Table 3.

Table 3.Comparison of Size and Emissions of Selected Economies
PPP-adjusted GDP as share of world totalPopulation as share of world totalGHG emission as share of world total
Brazil3.23.22.7
Canada1.50.51.8
China16.418.923.7
India6.617.86.3
Indonesia2.53.54.5
Japan4.61.82.8
Mexico2.01.71.5
Russian Federation3.62.04.3
United States16.34.412.9
European Union (28)17.57.07.9
Nicaragua0.10.10.03
Source: World Resources Institute, all data as of 2013.
Source: World Resources Institute, all data as of 2013.

7. The expected costs of climate change in Nicaragua are likely to be high. While there are no econometric studies on the impact of climate change on Nicaragua’s growth, it could be inferred from global research and studies on country groups with attributes similar to Nicaragua—in particular, initial temperature and income level. Low per capita income, high initial temperature, and a relatively large contribution of the agricultural sector to GDP and employment, increase Nicaragua’s vulnerability to climate change risks. The limited available resources and, therefore, low adaptive capacity, may also increase the cost of climate change. Estimates of the impact of climate change are:

  • Assuming that the path of climate change is linear and that its negative impact on productivity growth is 1 percent per 1 °C of warming, this would translate into an annual productivity loss of 0.04 percentage points lower compared with the scenario with no climate change.
  • Applying the findings of Dell, Jones and Olken (2012), a 1 °C increase in average temperature would reduce Nicaragua’s GDP growth by 1.3 percent. Thus, the negative impact on Nicaragua’s GDP growth would be 0.05 percentage points per year compared with the scenario with no climate change.
  • Climate change is projected to reduce annual agriculture output by 0.1 percentage points compared with a scenario without climate change.

B. Macroeconomic Impact of Disasters

Regional Context

8. Climate-related disasters have increased steadily during the last 4 decades worldwide, and in Latin America and the Caribbean in particular (Figure 4)2. Climatic disasters increased by 326 percent during 1970–2010, driven mainly by the growth of storms, which increased by 453 percent. Storms in Central America and the Caribbean increased fivefold, while other climate disasters increased by over 400 percent and 300 percent, respectively.

Figure 4.Number of Natural Disasters Events (1970–2016)

Source: EM-DAT.

9. CAPDR3countries are disproportionally exposed to disasters. During 1950–2014, there were 478 disaster events4 in the CAPDR region. While the land and population of the region is less than one percent of the world’s total, the number of disasters in the region account for over 5 percent of the total events in the world during this period.

10. Nicaragua is among the most vulnerable CAPDR countries. Nicaragua is the fourth country in the world by number of disasters.56 According to the international Disaster Database maintained by the Center for Research on the Epidemiology of Disasters (EM-DAT),7 there were 78 disaster events during 1900–2016 in Nicaragua, indicating a frequency of 0.7 disasters per year. During 1950–2014, each event on average had a reported economic cost of 2.2 percent of GDP8, affecting 1.5 percent of the population per event (Table 4). Nicaragua ranks third in CAPDR by number of disaster events occurred during 1950–2016, after Guatemala and Honduras. However, in terms of average economic cost, Nicaragua ranks first in the region (Table 5 and Figure 5).

Table 4.Summary of Natural Disasters 1900–2016
Disaster TypeNumber of EventsTotal DeathsNumber of People AffectedTotal Damage (million US$)
Drought51,013,00018
Earthquake1012,688748,175890
Epidemic115420,8980.007
Flood23557684,4612.1
Landslide1295,769
Storm203,9201,719,4771757.2
Volcanic Activity51321,3702.7
Wildfire316,00080
Source: EM-DAT.
Source: EM-DAT.
Table 5.CAPDR: Natural Disasters (1950–2016)
EpidemicDroughts/ WildfireEarthquakes/ Volcanic ActivityFlood / LandslideStormsTotal
Costa Rica262029865
Dominican Rep841283071
El Salvador10610181458
Guatemala9824341489
Honduras9125342181
Nicaragua12813222176
Panama54437555
CAPDR total554877202113495
Global1381107113855374380913020
Source: EM-DAT.
Source: EM-DAT.

Figure 5.CAPDR: Average Economic Cost of Natural Disasters (1950–2014)

11. The high frequency of disasters in Nicaragua can largely be attributed to the geological and geomorphological characteristic of the country. Nicaragua is located between the Cocos and Caribbean tectonic plates where seismic activities are frequent (Figure 6). There are 25 volcanoes in Nicaragua, five of which are considered active and two additional had eruptive activities in the last 200 years. According to the Nicaragua Institute of Territorial Studies (Instituto Nicaragüense de Estudios Territoriales, INETER), 37 percent (i.e. about 65 municipalities) of the 153 municipalities in Nicaragua present some level of earthquake risks, of which 47 percent are classified as high risk. The seismic activities concentrate on the Pacific region, which is the most developed of the country, concentrating 75 percent of the population and about 90 percent of the economic activity.

Figure 6.Illustration of Coco and Caribbean Plates

Source: Geology.com

12. Risk of floods and landslides is higher in the central region while storms occur mainly in the Atlantic region. The Central and Atlantic regions are less developed than the Pacific coast. The presence of mountainous areas and high precipitation, plus the influence of tropical storms originating in the Caribbean Sea, make the Central region of the country particularly exposed to floods and landslides. The Atlantic region, however, presents a high risk of tropical storms. While the number of storms reported by the database is lower than that of floods, they impacted a larger proportion of the population (Figure 7).

Figure 7.Composition of Natural Disasters by Type and People Affected

(1900–2016, in percent)

13. Nicaragua’s economic structure increases its vulnerability to disasters. The large share of agriculture, a productive sector highly exposed to CCDs, in output and employment constitutes an additional source of vulnerability.9 As of end-2016, agriculture, livestock and fishing contributed 14 percent of Nicaragua’s GDP, 8.4 percent of formal employment (Figure 8), and most informal employment. Exports of agricultural products account for about 30 percent of total exports of goods.

Figure 8.Share of Agriculture, Livestock and Fishing

(In percent)

14. The impact of disasters can be exacerbated by structural factors. While geographic location determines largely the number and intensity of disasters, structural factors such as poverty may constrain the ability to build up resilience and intensify vulnerability to disasters. As of 2014, 29.6 percent of the Nicaraguan population lived under the national poverty line. Building standards are inadequate to face the risks of disasters and are insufficiently enforced, which could further exacerbate the costs of disasters. According to UNISDR and CEPREDENAC,10 approximately 70 percent of the housing constructions do not provide sufficient security against disasters.

15. Nicaragua’s shallow financial markets significantly limit the capacity for risk transfer and for post-disaster relief and reconstruction financing. The insurance industry is underdeveloped, with total assets of less than 2½ percent of GDP, and insurance products against disasters are very limited.

Quantitative Analysis

16. The quantitative analysis of disasters poses important challenges. First, the impact of disasters may not be adequately captured by available data. Most data are reported on a calendar basis, whereas disasters and their impacts have widely varying durations, frequently overlapping two years. Second, other factors could affect the observed the impact of disasters on macroeconomic variables. Therefore, econometric techniques are combined with intuitive methodologies to control for relevant exogenous variables and better understand the impact of disasters on output. Third, the limited number of country observations frequently prevents meaningful country by country econometric studies. Finally, different types of disasters—floods, storms, earthquakes and droughts—should be analyzed separately, as they may have different impact patterns.

17. Event studies indicate that disasters have short-term negative impacts on GDP growth. For CAPDR countries, the most severe disaster events11 decelerate GDP growth by about 2 percentage points on the event year, but GDP growth tends to accelerate by about 3.1 percent the following year, possibly due to reconstruction efforts. The comparison of impacts on GDP growth rates show that, among the four types of events with higher incidence in the region, storms seem to have the largest impact and strongest recovery (Figure 9). Event studies, however, do not control for other factors affecting GDP growth and, therefore, no causality could be established without an econometric analysis.

Figure 9.CAPDR: Event Analysis Impact of the Most Severe Events on Real GDP Growth

18. The empirical analysis for the Central American and Caribbean region confirms that disaster events, apart from drought, have a substantial negative impact on output growth. Following Fomby (2013) and Acevedo (2014), a vector auto-regression model (VAR) with exogenous shocks is constructed, controlling for domestic and external conditions.12 The model estimates the dynamic effects on GDP growth from each of the four categories of disasters more relevant in the region.13 Given the relatively similar exposure to disasters of the Caribbean region and CAPDR, the model is first run pooling the 18 countries together.14 The impulse response functions show that earthquakes, floods and storms have an immediate negative impact on output growth ranging from 0.8 percentage points for floods to 1.9 percentage points for earthquakes (Figure 10). Although growth tends to recover in about three years, the damage to the output level is permanent. The direction of the impact of disasters on GDP growth is consistent with Acevedo (2014) estimates. Results on impact from droughts are inconclusive, as they seem to follow differing intra-regional dynamics.15

Figure 10.CAPDR and Caribbean: IRF of GDP Growth to Disasters

19. Floods and droughts have a greater impact on growth in CAPDR, compared with Caribbean countries. Results for CAPDR countries indicate that floods have slightly greater negative impact than when the model is run for the pool of CAPDR and Caribbean countries (Figure 11).16 The impact of droughts on CAPDR countries is consistent with intuition: an immediate negative deviation from the GDP growth baseline of 1.2 percentage points, which recovers in about 3 years.17

Figure 11.CAPDR Countries: IRF of GDP Growth to Disasters

20. Disasters have negative impacts on fiscal revenue, exports and agriculture. For CAPDR countries, the median estimates indicate that all categories of events cause a decline in the share of revenue as percent of GDP in the year of the event, which recovers in about 2 years. Earthquakes cause the large impact on revenue (about 5 percent of GDP on the event year), although they also show the strongest recovery ratio (Figure 12). The loss in tax revenue in absolute terms is more significant given that output growth already slows down in the event year.

Figure 12.CAPDR Countries: IRF of Revenue to Disasters

21. Impact of climatic disasters on exports is lagged. Storms, droughts and floods reduce the growth of export-to-GDP ratio by a range of 11 to 24 percentage points 1 to 2 years after the event. Exports tend to recover only after 2 to 4 years after the event (Figure 13). The timing of the events, largely linked to the rain and hurricane season from May to October, the harvest season, which for most agricultural export product extends from October to March, and the time required to process export products, may partially explain these lags. The impact of the only geological disaster considered, earthquakes, is contemporaneous with the observed reduction in exports, possibly because it might affect directly export processing facilities and transport infrastructures.

Figure 13.CAPDR Countries: IRF of Export to Disasters

22. As anticipated, climatic disaster events are found to have a negative impact on the agricultural sector. Droughts, storms and floods reduce the growth of share of agriculture products in total primary commodity exports by 15 percent to 51 percent in the event year. The impact of earthquakes, however, appears to be less significant (Chart 14).

Figure 14.CAPDR Countries: IRF of Agriculture to Disasters

23. The impact of disasters on GDP growth and fiscal revenue in Nicaragua is estimated to be among the highest in CAPDR. While there is insufficient data to run the model for Nicaragua independently, the model was adapted to estimate the impact of floods and storms.18 The result indicates that, on average, impact is greater than those observed for the average CAPDR country during the year event (Table 6), except for the impact of floods on GDP growth, which is 0.4 percentage point smaller in the case of Nicaragua. Estimates of the decline in Nicaragua’s revenue to GDP growth ratio are particularly large compared with its regional peers, possibly derived from the larger contribution of the agriculture sector to fiscal revenues. However, the smaller sample size increases the uncertainty of the estimates within a larger confidence band.

Table 6.Impact of Storms and Floods on GDP and Fiscal Revenue
GDP growth (decline, pp)CAPDRNICRevenue to GDP growth (decline, pp)CAPDRNIC
Storm0.851.74Storm0.522.5
Flood1.010.61Flood2.048.68
Overall0.931.18Overall1.285.59
Source: Fund staff estimation.
Source: Fund staff estimation.

C. Fiscal Preparedness

24. Nicaragua lacks fiscal resources to deal with disaster events. The public sector is directly and indirectly affected by disasters. In addition to the loss revenue estimated in the previous section, the costs of humanitarian aid and infrastructure reconstruction, among other, will increase fiscal expenditure. The sufficiency of fiscal space to address the losses from an extreme catastrophic event is measured by the IDB’s Disaster Deficit Index (IDD).19 The IDD compares the losses generated by extreme events with the available public sector resources, considering the probability of occurrence of these extreme events within the next 10 years. An IDD greater than 1 indicates that the country does not have the economic capacity to deal with disasters of that scale. The greater the IDD, the larger the gap between fiscal space and potential fiscal losses from disasters. For Nicaragua, the IDD has been consistently greater than 1 (Table 7), indicating that in an extreme event,20 Nicaragua would not have sufficient fiscal resources or accessible financing to pay for the losses and replenish the capital stock affected. This index has been growing in time, indicating that the fiscal space has not coped with the increase in frequency and magnitude of disaster events. If a disaster of a severity equal to the largest that occurred in the last 50 years had stricken Nicaragua in 2012, the country would have necessitated 2.74 times the available fiscal space to cope with the fiscal impact.

Table 7.Evolution of IDD
2000200520102012
IDD501.171.292.492.74
IDD1002.522.754.845.22
IDD5004.024.246.076.30
Source: IDB (2015).
Source: IDB (2015).

25. Revenue loss due to severe disasters will reduce fiscal space. As an alternative to the IDD, which is based on the extreme events’ impact, Table 8 shows the Fund staff’s econometric model estimates on the average impact of each type of severe disasters event on revenue, which ranges from 0.1 to 0.4 percent of GDP. Floods pose the largest risk of fiscal losses due both to their higher frequency and average revenue impact. Total fiscal impact is likely to be well above these figures, as the fiscal cost to repair public infrastructures, humanitarian aid and other public expenses are not included in these estimates. Given that the fiscal space in Nicaragua is limited, it is likely that the event of a severe flood would have a substantial impact on fiscal resources. To ensure fiscal stability, additional fiscal space needs to be built.

Table 8.Estimation of Impaction on Revenue
StormFloodEarthquakeDrought
Number of Events in Model8954
Probability0.120.140.080.06
Impact on revenue as % of GDP−0.16−0.39−0.09−0.11
Source: EM-DAT and staff calculation.
Source: EM-DAT and staff calculation.

D. Policy Response21

Adaptation Measures

26. Nicaragua has taken several measures to adapt to CCDs’ risks. At the technical level, the INETER plays an important role in developing a knowledge base and reinforcing the awareness to the risk of disasters. Hazards and vulnerabilities have been mapped for the most vulnerable municipalities in the country. Some building codes have been upgraded and enforcement has improved. Developing an early warning system and improve dissemination of information can significantly enhance preparedness and reduce events’ impact. The World Bank estimates that every U.S. dollar invested in early warning system yields US$4 in reduced losses.22

27. Efforts are ongoing to strengthen the resilience of the agriculture sector. With assistance from international organizations, progress has been made in diversifying agricultural products, extending irrigation and improving the resilience of crops to weather conditions. The Nicaraguan Institute of Insurance (INISER) have launched a new Agricultural and Livestock Insurance policy that offers protection to agricultural producers in the event of hazards such as climatic phenomena or biological hazards. This insurance product comes to fill an important gap in the range of financial services to cover CCDs’ risks.

Mitigation Measures

28. Nicaragua adopted a comprehensive and multi-sectoral approach to disaster risk management. In 2000, Nicaragua created the national disaster prevention and response plan and established the National System for Disaster Management and Prevention (SINAPRED) to coordinate the efforts and resources in responding to disasters in a timely and effective manner, as well as in rehabilitating and rebuilding the areas affected after the events. SINAPRED is also involved in strengthening the capacity of response to disasters. Prevention, mitigation and disaster relief is an integral part of the National Plan for Human Development, a top-priority, broad-based policy program of the government. The Plan confers SINAPRED an important role in issuing guidance to municipalities and individuals. Within the Plan, local communities, trade unions, and the civil society at large are part of the civil effort to implement adaptation, mitigation and disaster recovery measures, starting at the most basic level to raise citizens’ awareness on how to react in case of disaster events.

29. Significant progress has been made to improve financial preparedness. Nicaragua established a National Disaster Fund (NDF), managed by the executive secretariat of SINAPRED. The size of the NDF, however, is insufficient to cover the fiscal costs of disasters. In 2016, the 40 million córdobas allocated to the NDF (about US$1.4 million), were totally spent and no remnant was left for the following years. Law 337 mandates that local governments allocate funds for risk management activities within their jurisdictions. Nicaragua has made good use of the Caribbean Catastrophe Risk Insurance Facility (CCRIF). The CCRIF is a regional catastrophe risk insurance scheme developed under the technical leadership of the World Bank and financed by member countries and donors. While the Council of Finance Ministers of Central America (COSEFIN) negotiated the extension of the scheme to CAPDR countries in 2015, Nicaragua is the only country so far to subscribe to the negotiated policy. Nicaragua’s annual premium of US$3.5 million was paid by the World Bank. The country received catastrophe insurance payouts of US$1.6 million during 2016.23 Nicaragua also acquired contingent credit lines for disasters from the World Bank and IDB. If a disaster of certain magnitude strikes, the IDB would be ready to make US$156 million available to the country. Concurrently, the World Bank would frontload all resources available in the pipeline.

30. The World Bank is assisting in developing a reforestation plan. The plan aims to reduce CO2 emissions by 11 metric tons in 20 years through reforestation and prevention of deforestation and forest degradation. The program will be partly financed by the Green Climate Fund (GCF). GCF is designed to help developing countries finance clean energy, other mitigation efforts and adaptation to climate change. The fund is financed by major industrial countries, with the World Bank operating as its trustee. For lower income countries, it is advisable to continue exploring further opportunities to access international donors’ resources to help financing mitigation measures.

31. The use of renewable energies is increasing exponentially. Clean primary energy sources already account for more than half of the primary electricity matrix (Table 9), while in 2006 their contribution was of only 30 percent. Nicaragua has abundant renewable resources and their use for electricity generation has been promoted through tax incentives. While hydroelectrical energy might face challenges from the impact of global warming on water reserves, geothermal and solar energy have a strong potential. A plan to increase the contribution of renewable energy sources to over 90 percent by 2020 is ongoing.

Table 9.Power Generation in 2015
(GWh)Share of total
Thermal268959.4
Hydroelectrical2946.5
Gas Turbine20.1
Geothermal67815.0
Wind86519.1
Solar20.05
Memorandum item
Clean energy share of total50.6
Energy from petroleum49.9
National Interconnected System4531100
Source: National authorities.
Source: National authorities.

32. The Nicaraguan authorities consider the Paris Agreement insufficient.24 Nicaragua is one of the few countries that did not sign the Paris agreement. The authorities believe that the goal of the agreement, i.e. reducing global warming to between 2 °C and 3 °C, fell short of the needs to contain global warming. Large industrial countries responsible for most CO2 emissions did not take enough responsibility, agreed objectives were insufficient, and agreements to limit emissions were not legally binding. At the same time, small countries like Nicaragua continue to be vulnerable to the consequences of climate change without any specific compensation included in the agreement. However, despite the rejection to the agreement, the government is engaged in a high priority comprehensive plan to adapt and mitigate the effects of CCDs, as part of the National Plan for Human Development.

Macroeconomic policies

33. Macroeconomic policies have an important role in improving resilience and reducing the impact of disasters and climate change. While there is a wide range of policies and actions that would have a bearing in reducing the vulnerabilities to CCDs, this section will focus on macroeconomic policy actions where the Fund has comparative advantage.

Fiscal policy

34. CCDs’ risk management should be undertaken within a comprehensive public financial management framework. As discussed in Box 3 of the Staff Report, together with macroeconomic shocks and risks stemming from the social security institute and SOEs, climate change is among the top risks faced by public sector finances. As a first step, it is important to identify and quantify the relevant risks of disasters and climate change and inform the macroeconomic policy framework. The legislature and the public should have access to information on the most relevant risks and how the government plans to address them. This can be achieved by including CCDs’ risk in a fiscal risk annual report to be incorporated to the medium-term budgetary framework. The fiscal risk report could describe and quantify the main fiscal risks, discuss their likelihood, and propose fiscal measures to mitigate and manage them. Sound macroeconomic data and fiscal transparency are critical for risk mitigation and contingency planning.

35. Public investment in resilient infrastructure and incentives to encourage private sector investment in CCDs’ risk mitigation are important components of a risk management strategy. Despite progress, there remain significant infrastructure gaps in Nicaragua. Public spending on risk reduction needs to be consistent with fiscal space, debt sustainability, and absorption capacity. It is also important to continue to invest in education and healthcare to further reduce poverty and foster inclusive growth. Social safety nets need to be strengthened to help the households in poverty better deal with the impacts of disaster events. The private sector should be given appropriate incentives to encourage private investments in risk adaptation and mitigation. Appropriate zoning rules and building codes can help ensure that physical structures are strong enough to withstand disasters.

36. Fiscal policy needs to be counter-cyclical and adequate fiscal space should be built through public savings. The fiscal stance should consider the need to progressively build contingent buffers in response to CCD risks. Thus, fiscal policy needs to be broadly counter-cyclical, creating fiscal space in non-disaster years that can be used to offset the adverse impact of future disaster events on public finances. Taking into consideration of the demand for disaster assistance and re-construction, the authorities should gradually build up a disasters-specific fiscal buffer of at least the average revenue cost of natural disasters plus the estimated impact on expenditure. It is important, however, that the fiscal effort to create additional fiscal space is spread along a sufficient timespan to not jeopardizing social and infrastructure programs critical for maintaining high rates of growth and reducing inequality. The size of this buffer should be reviewed at least annually in the context of the medium-term budget framework.

37. Energy prices should be allowed to reflect the full range of environmental impacts. Although Nicaragua contributes little to the global greenhouse gases, an appropriate pricing policy can help the country embark on a more environmental-friendly development strategy and improve revenue. Subsidies to electricity and public transportation need to be reduced. Electricity subsidies are estimated at 0.6 of GDP in 2016, and financed by both public and private resources. Subsidy is also provided to public transportation through reduced price for diesel and the VAT preferences. These subsidies are costly and inefficient—most of these subsidies are received by the households in the higher welfare quintiles.

Monetary, Financial and Exchange Rate Policies

38. Further strengthening the financial regulatory and supervisory framework would increase resilience of financial institutions to climate change risks. Disasters can threaten the health of the financial sector by undermining the repayment capacity of borrowers affected by disaster events and, thus, worsen asset quality. In addition to fully integrating CCDs’ risks into the risk analysis and management system of financial institutions, increasing bank capital buffers and technical reserves for the insurance industry, taking into account exposure to CCD in provisioning policies, and a developing a reinsurance market that reduces the cost of catastrophic insurance, are among the measures conducive to enhance the capacity of the financial sector as whole to deal with disasters.

39. Underdeveloped financial markets may delay or prevent the efficient reallocation of risks and financial resources. Nicaragua can benefit from strengthening the legal and institutional basis of financial markets and making progress in improving financial literacy and financial inclusion. Financial deepening can help transfer the risks to entities most capable of bearing those risks. For instance, increasing access to financing and insurance for households and business can help mitigate financial stress.

40. Under the current exchange rate framework, the optimal level of gross international reserves would be above conventional metrics. Given the high exposure to CCDs, and the increase in foreign currency demand associated to events, the central bank may have to conduct substantial foreign exchange interventions to maintain exchange rate stability within the crawling peg framework. Thus, a higher level of reserves will help prevent disorderly foreign exchange market developments. Eventually, the authorities may consider introducing some flexibility to allow the exchange rate to absorb external shocks and reduce the macroeconomic cost of CCDs.

The Role of the IMF

41. The IMF assists in building resilience to CCDs through policy advice, capacity building, and financing. This paper is part of several pilots to better integrate the assessment on CCDs’ risk within IMF’s surveillance. The Fiscal Affairs Department of the IMF delivers technical assistance and training in topics related to climate change, particularly carbon taxation. The IMF’s Rapid Credit Facility (RCF) and Rapid Finance Instrument (RFI) provide prompt assistance to countries with emergency balance of payments needs. The Fund recognizes the possibility that disasters may become more frequent and damaging than in the past, including because of climate change, and recently increased the annual access limits under the RCF and RFI from 37.5 percent of the quota to 60 percent of the quota.

Annex I. Methodological Annex

1. The methodology to estimate the macroeconomic impact of disasters follows closely Acevedo (2014). Acevedo (2014) estimated the mean response of growth and debt to natural disasters in 12 Caribbean countries using vector auto regression model with exogenous variables. This paper estimates the macroeconomic impact of natural disasters in Nicaragua within the Central American and Caribbean context, using the same methodology.

2. The use of complementary data sources improved the estimates. Due to shortcomings in the Penn World Tables used in Acevedo (2014),1 the information on macroeconomic variables in the Penn World Tables (v 9.0) was complemented with data from the IMF World Economic Outlook (2016) and the World Bank World Development Indicators (WDI) (Table 1).2 The source for disaster event data remains the Emergency Disaster Database (EM-DAT). The panel dataset includes series for 18 countries over the period 1950–2016. Data description is provided in Table 2.

Table 1.Source of Variables
VariablesDefinitionSources
Real GDP growthAnnual growth rate of real GDPIMF, World Economic Outlook
Government revenue to GDP growthAnnual growth rate of general government revenueIMF, World Economic Outlook
Investment share of GDP growthAnnual growth rate of investment as a share of real GDPIMF, World Economic Outlook
Consumption share of GDP growthAnnual growth rate of consumption as a share of real GDPIMF, World Economic Outlook
Inflation rateInflation rateIMF, World Economic Outlook
Trade openness growthAnnual growth rate of of the sum of exports and import as share of real GDPIMF, World Economic Outlook
Export share of GDP growthAnnual growth rate of real export to GDP sharePenn World Tables v.9.0 (variable openk)
Agriculture export of total export growthAnnual growth rate of agricultural raw materials exports (% of merchandise exports)World Bank, World Development Indicators
Financial depth growthAnnual growth rate of domestic credit to private sector as a share of GDPIMF, World Economic Outlook
Terms of trade growthAnnual growth rate of term of trade of good and service indexIMF, World Economic Outlook
World real GDP growthAnnual growth rate of world’s real GDPIMF, World Economic Outlook
Natural disaster variablesDefined in textEM-DAT
Table 2.Variable Description
VariableCAPDR and Caribbean CountriesCAPDR Countries
ObsMeanStd. Dev.MinMaxObsMeanStd. Dev.MinMax
Real GDP growth9753.574.12−26.4818.853874.053.99−26.4814.19
Consumpti on share of GDP growth7850.369.48−71.26156.933210.023.22−12.3419.45
Investment share of GDP growth7071.3917.68−72.85213.783252.2820.82−72.85213.78
Trade openness growth8130.4311.51−71.50117.063211.2811.94−28.61117.06
Government revenue to GDP growth4581.027.94−31.4028.211560.855.90−19.8718.77
Credit to GDP ratio growth8132.8114.12−57.57223.773793.5217.52−57.57223.77
Inflation rate97325.46300.33−14.747428.7037055.33485.85−14.747428.70
Agriculture export of total export growth64045.72362.16−99.625592.363328.36103.96−90.351772.43
Export share of GDP growth9866.7467.10−94.821006.634466.4564.73−94.821006.63
Terms of trade growth8350.8113.05−43.73271.713161.4417.79−30.05271.71
World real GDP growth9703.951.45−0.106.813773.951.45−0.106.81
Storm12040.080.270.001.004680.070.250.001.00
Flood12040.050.230.001.004680.100.300.001.00
Earthquake12040.030.160.001.004680.070.250.001.00
Drought12040.030.160.001.004680.040.210.001.00

3. A dummy variable is used to determine the macroeconomic impact of each disaster. As there are many disasters that do not have substantial impact, the estimates consider only severe events (Table 3). Severe disasters are defined as events which affect more than 0.1 percent of total population.3 The severity dummy takes a value of 1 if it meets this threshold. This assumes that disasters with a significant macroeconomic impact are normally associated with a higher number of fatalities and individuals affected.

Table 3.CAPDR and Caribbean Countries: Number of Severe Events
CountryStormFloodEarthquakeDrought
Antigua and Barbuda6001
Bahamas, The8000
Barbados3000
Costa Rica5960
Dominica8010
Dominican Republic5411
Grenada2000
Guatemala4485
Honduras51238
Haiti13918
Jamaica7502
St. Kitts and Nevis4000
St. Lucia4200
Nicaragua8954
Panama1621
El Salvador3362
Trinidad and Tobago1000
St. Vincent and the Grenadines5300
Total92663332

4. Model specification. The model is set up as a fixed effects unbalanced panel with exogenous variables (VARX), and a pth order vector auto regression with exogenous variable x can be written as:

where yt is a vector of K endogenous variables, each modeled as function of p lags of those variables and a set of exogenous variables xt, which include the severity dummy variables, world GDP growth, and terms of trade changes. The error term in the system is assumed to be both homogenous with mean zero and serially uncorrelated within and between equations. With the presence of lagged dependent variables in the right-hand side of the system of equations, however, estimates would be biased even with large N (Nickell, 1981).4 As a remedy, consistent estimates are obtained using the Generalized Method of Moments (GMM) proposed by Arellano and Bover (1995).5

5. Selection of variables. To assess the impact of disasters on GDP and fiscal revenue, the benchmark model investigates the impact of six exogenous variables on various endogenous variables presented in Table 4. To ensure stationarity of the time series involved, all variables are calculated as growth rates. The results presented in Table 5 indicate that the null hypothesis of a unit root is rejected for all series included. The impact on export and agricultural sector is estimated with two alternative model specifications to avoid further increasing the number of variables.6 In the first one, the export-to-GDP ratio is used instead of trade openness. In the second specification, agriculture sector performance, proxied by the share of agricultural raw materials in total merchandise exports, replaces the revenue to GDP ratio.7,8

Table 4.Endogenous and Exogenous Variables
Endogenous VariableExogenous Variable
Real GDP growthStorm
Government revenue to GDP ratio growthFlood
Investment share of GDP growthEarthquake
Consumption share of GDP growthDrought
Inflation rateTerms of trade
Private credit to GDP growthWorld GDP growth
Trade openness growth
Table 5.Im-Pesaran-Shin unit-root test
VariableStatisticp-value
Real GDP growth−12.300.00
Consumption share of GDP growth−19.320.00
Investment share of GDP growth−18.210.00
Trade openness growth−16.820.00
Government revenue to GDP growth−10.710.00
Credit to GDP ratio growth−13.860.00
Inflation rate−6.160.00
Agriculture export of total export growth−11.230.00
Export share of GDP growth−18.100.00
Terms of trade growth−18.190.00
World real GDP growth−14.220.00

6. Diagnostic tests. To ensure model stability and to determine the lag structure of the model, stability condition and lag-selection tests were performed. Results of the eigenvalue condition for the benchmark model indicate that the VAR model satisfies the stability criteria (Table 6).9 The optimal lag order was selected based on consistent moment and model selection criteria (MBIC, MAIC and MQIC), which is analogous to maximum likelihood-based model selection criteria. In this case, first order panel VAR is the preferred model, since it has the smallest MBIC, MAIC and MQIC statistics for all model specifications (Table 7).10

Table 6.Model Stability
Eigenvalue
RealImaginaryModulus
0.890.000.89
0.070.270.28
0.07−0.270.28
0.14−0.110.18
0.140.110.18
−0.170.000.17
−0.030.000.03
All the eigenvalues lie inside the unit circle. pVAR satisfies stability condition.
All the eigenvalues lie inside the unit circle. pVAR satisfies stability condition.
Table 7.Lag Selection Criteria
lagCDJJ pvalueMBICMAICMQIC
10.9169.00.1−670.9−125.0−343.4
21.0101.60.4−458.4−94.4−240.0
30.950.30.4−229.7−47.7−120.5

7. Impulse and response functions. As the VAR is confirmed to be stable after the stationarity test, it can safely be rewritten in moving average form as:

The formula above shows the vector moving average representation of the VAR, where the endogenous variables are expressed as a function of a constant vector (μ), the exogenous variables (x) and the current and past values of the error terms. To extract and visualize the disaster impact, we use the coefficient Di (normally referred as dynamic multiplier functions or transfer functions) on the exogenous disaster variables to derive the impulse and response functions, which illustrate both the contemporaneous shift and subsequent dynamics of macroeconomic conditions due to a disaster event. An upper and lower bound are reported to represent a 95 percent confidence interval using Monte Carlo simulation. Thus, the response of the growth rate of four main economic variables (real GDP, export-to-GDP ratio, revenue-to-GDP ratio and agriculture share of exports) to the shock of each disaster type (storm, flood, earthquake and drought) are presented separately under different disaster scenarios.

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1

Prepared by Fang Yang and Xiaodan Ding. Staff appreciates contributions and comments received from the authorities, including the National System for Disaster Management and Prevention (SINAPRED); Mr. Guillermo Gonzalez, Climate Change Advisor to the Presidency of the Republic of Nicaragua; Mr. Paul Oquist, Member of the Economic Council of the Presidency, and from Mr. Victor Campos, Director of the private sector think tank Centro Humboldt.

2

In line with the recent change in terms in the specialized literature, this paper uses the term “disasters” instead of “natural disasters”. The reason is that, while these events have natural causes, the disasters are also consequence of vulnerabilities generated by the human activities.

3

While there is anecdotal evidence of the relationship between the increase in frequency of climate-related, global warming and the change in climate patterns (Van Aalst, 2006), several researchers explain the statistical relationship because of improved monitoring rather than more disasters actually taking place. There seems to be consensus that, albeit uncertain, outcomes of an increase in global temperatures include more and more intense climate-related disasters. (Riebeek, H., 2005).

1

See IPCC (2014). Note that warming projections are highly uncertain due to poorly understood feedbacks in the climate system.

2

Other risks include changes in precipitation patterns, sea level rises, more intense and frequent extreme weather, destruction of the marine food chain from ocean acidification, and changes in ocean circulation, which are at the origin of climatic disasters.

3

The estimations are typically by the year 2100.

3

Costa Rica, El Salvador, Guatemala, Honduras, Nicaragua, Panama and Dominican Republic.

4

44 droughts, 78 earthquakes and volcanic activities, 188 floods and landslides, and 113 storms.

5

After Honduras, Myanmar and Haiti, based on Global Climate Risk Index 1996–2015 data (Kreft, Eckstain and Melchior, 2017). The Climate Risk Index indicates the level of exposure and vulnerability to extreme events. It is based on data on past events and should not be used for linear projection of future impacts.

6

Nicaragua ranks 158 out of 173 countries in World Risk Index which considers a country’s vulnerability and its exposure to natural hazards. The WRI measures the risk of becoming a victim of a disaster as a result of vulnerability and natural hazards such as earthquakes, storms, floods, droughts and sea level rise. The higher the rank, the more risk it indicates.

7

The EM-DAT database includes all disasters meeting one of the following criteria: 10 people killed, 100 people affected (injured, homeless, or requiring immediate assistance such as food, water, sanitation, and medical assistance), a declaration of a state of emergency, or a call for international assistance. It contains essential core data on the occurrence and impact of over 22,000 mass disasters in the world from 1900 to 2016. The database is compiled from various sources, including UN agencies, non-governmental organizations, insurance companies, research institutes and press agencies.

8

GDP in PPP terms reported by Penn World Table.

10

United Nations Office for the Reduction of Disasters (UNISDR) and the Center for the Coordination of Natural Disaster Prevention in Central America (CEPREDENAC), 2015

11

Each country’s most severe events in each category based on the population affected are selected. Impact on GDP growth is measured in simple average of the relevant countries.

12

See the Appendix for a full description of the model.

13

The analysis includes disaster events beyond a minimum threshold. The threshold considered is defined as the ratio of people affected (number of fatalities plus 0.3 times the number of people affected) to total population being greater than 0.1 percent. This threshold applies to storms, floods and droughts events. For earthquake events, the threshold applied is 0.01 percent.

14

Antigua and Barbuda, the Bahamas, Barbados, Costa Rica, Dominica, Dominican Republic, Grenada, Guatemala, Haiti, Honduras, Jamaica, Nicaragua, Panama, el Salvador, St. Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines, and Trinidad and Tobago.

15

Results should be interpreted with caution due to the large standard errors of some estimates. Mean impulse- response functions can mask important case-specific differences. Large standard deviations are consistent with the large tail risks on disasters’ impact.

16

Acevedo (2014) estimated a higher the impact of floods on GDP growth in the Caribbean (3 percent), which could be explained by the longer period and improvements in our data series (see Appendix).

17

It is possible that the lower agricultural contribution to GDP in most Caribbean countries makes their growth less sensitive to droughts. Furthermore, the tourism industry—which is relatively more important to Caribbean countries—may marginally benefit from extended dry periods. The same considerations affect the Caribbean coastal regions of CAPDR, as well the Dominican Republic. Together with the gap between rainfall and harvest, which tend to happen in different calendar years for the main export products, these could explain the relatively moderate observed incidence of droughts in CAPDR.

18

Data on droughts and earthquakes events was insufficient to estimate their impact even under the simplified model.

20

The IDD measures three scenarios of extreme events: IDD50, the largest event that occurred in the last 50 years occurs within the next 10 years; IDD100, largest event that occurred in the last 100 years occurs within the next 10 years; and IDD500, the largest event that occurred in the last 500 years occurs within the next 10 years.

21

See also IMF, 2016.

23

Corresponding to an earthquake near Chinandega in June 2016, and Hurricane Otto in December 2016.

1

Some series present gaps and the latest available data corresponds to 2014.

2

Specifically, investment share of GDP, consumption share of GDP and trade openness are complemented with IMF WEO data.

3

The affected population is calculated as the weighted average of the number of fatalities (with weight of 1) and the number of total affected individuals (with a weight of 0.3). Due to its lower frequency of occurrence, the threshold for earthquakes is set at 0.01 percent with a full weight on individuals affected to capture sufficient observations. The impact of earthquakes, thus, is likely to be underestimated.

4

Though the bias approaches zero as T gets larger.

5

Instead of using first difference transformation, the GMM proposed by Arellano and Bover (1995) subtracts the average from all available future observations from the current observation, thereby minimizing data loss.

6

Adding the exports and agriculture variables to the benchmark model without excluding any variables would result in over-identification, leading to non-convergence.

7

Given the high volatility of the agriculture export share growth, extreme positive outliers are eliminated to reduce standard errors and improve accuracy of estimates.

8

Impact on GDP and fiscal revenue is robust across all model specifications.

9

Models under alternative specifications also fulfill the stability condition.

10

For simplicity, the table only presents the result of the benchmark model. Results of alternative model specifications result in the same lag selection.

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