Chapter

Chapter 5. Fiscal Challenges in the Caribbean: Coping with Natural Disasters

Author(s):
Krishna Srinivasan, Inci Otker, Uma Ramakrishnan, and Trevor Alleyne
Published Date:
November 2017
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Author(s)
İnci Ötker and Franz Loyola 

Introduction

The Caribbean economies face difficult fiscal challenges, reflected in their high and rising levels of deficits and debt. Large fiscal deficits and debt have been built up for a variety of reasons, ranging from lack of prudent macroeconomic policies and overspending by public enterprises, to costly financial crises that resulted in government intervention in the financial sector, to simply bad luck. In the Caribbean, like in many other small states and developing countries, bad luck includes frequent and severe natural disasters, which can result in a collapse of economic activity and erosion of fiscal buffers and undermine the sustainability of medium-term fiscal frameworks.

This chapter reviews the effects of natural disasters on economic growth and fiscal performance in the Caribbean. It draws on existing work within and outside the IMF to assess the impact of natural disasters on growth and fiscal performance and to identify how countries vulnerable to natural disasters and climate change can build resilience to disaster risk. It explores ways in which the Caribbean countries can reduce risks related to natural disasters and climate change, better prepare for them and mitigate their consequences when risks materialize, and respond to disasters in a way that facilitates rapid recovery.

Stylized Facts

The number of people affected by natural disasters around the world has been rising, making natural disasters an important source of fiscal challenge (Figure 5.1).1 Since 1950, more than 12,000 natural disasters have been registered globally (182 disasters a year, on average), affecting more than 7.6 million people (Table 5.1). Direct economic damages from disasters over this period amounted to $525 million per year in constant 2009 U.S. dollars (Figure 5.2). Just like the number of people affected, economic damage (involving both direct and indirect costs) has been rising, from an estimated $70 billion per year, on average, in the 1990s to $113 billion per year since 2000. This upward trend is expected to continue as the frequency and severity of disasters increase and the number of people in areas more exposed to natural disasters and climate change becomes more highly concentrated.

Figure 5.1.Number of Natural Disasters and Populations Affected, 1950–2016

Sources: EM-DAT; and IMF staff calculations.

Table 5.1.Natural Disasters Worldwide: Occurrence and Impact
World Excluding Caribbean
Number of OccurrencesNumber of Occurrences with Data on DeathsNumber of DeathsNumber of Occurrences with Data on AffectedNumber of AffectedNumber of Occurrences with Data on DamagesTotal Damages (in thousands of 2009 U.S. dollars)
1950–592872742,126,77011119,658,55971388,791
1960–695654751,750,121419199,337,760350970,629
1970–79886732986,765730543,099,2575211,710,565
1980–891,7901,495796,6311,5261,241,458,2421,0113,338,391
1990–992,9312,651527,5462,7012,022,082,1552,1219,320,225
2000–094,4234,152839,2454,2522,281,785,3892,7539,624,746
2010–162,5232,303450,1162,4251,309,547,8631,6489,811,489
Total13,40512,0827,477,19412,1647,616,969,2258,47535,164,836
Average per Year200180111,600182113,686,108126524,848
Average per619626,1904,149
The Caribbean
Number of OccurrencesNumber of Occurrences with Data on DeathsNumber of DeathsNumber of Occurrences with Data on AffectedNumber of AffectedNumber of Occurrences with Data on DamagesTotal Damages (in thousands of 2009 U.S. dollars)
1950–591191,0793270,200482,000
1960–6925166,44612467,87520379,340
1970–792110188161,508,930967,709
1980–895124632373,444,247312,283,881
1990–9958271,521473,918,138342,351,577
2000–0994786,829852,298,664525,488,539
2010–166444230,6755712,367,5073811,839,152
Total324208247,37025724,275,56118822,492,198
Average per Year533,7484367,8123340,791
Average per Disaster1,18994,457119,639
Sources: EM-DAT; and IMF staff calculations.
Sources: EM-DAT; and IMF staff calculations.

Figure 5.2.Economic Damage from Disasters, 1950–2016

(Billions of U.S. dollars)

Sources: EM-DAT; and IMF staff calculations.

Being in the cyclone and hurricane belts bordering the equator, where more frequent weather shocks are experienced, the Caribbean region has been highly exposed to natural disasters. Since 1950, the Caribbean has been hit by 324 natural disasters that killed close to 250,000 people and affected more than 24 million people, through injury or loss of homes, in addition to death. The economic impact of natural disasters has been substantial, exceeding $22 billion in constant 2009 U.S. dollars over the period 1950–2016, compared with $58 billion globally (including the Caribbean).

The Caribbean’s vulnerability to natural disasters is highly typical of small states, which are proportionately more exposed (IMF 2016a). For small states (developing countries with population up to 1.5 million), the economic cost of the average natural disaster during 1950–2014 was equivalent to nearly 13 percent of GDP, compared with less than 1 percent of GDP for larger states (Figure 5.3). Nearly 10 percent of disasters caused damage of more than 30 percent of GDP in small states, compared with less than 1 percent in larger countries. An average disaster affects 10 percent of the population in small states, compared with 1 percent for other states. Among small states, the average annual damage from disasters for the Caribbean is equivalent to 2.4 percent of GDP. The Caribbean small states have suffered more damage compared with other small states and larger states, and more populations have been affected in small states in general.

Figure 5.3.Average Annual Effects of Natural Disasters

Sources: EM-DAT; IMF, World Economic Outlook; World Bank, World Development Indicators; and IMF staff calculations.

Note: Average annual disaster damage, affected population per 1,000 per square kilometers.

The average impact of disasters within a given region can mask the magnitude of devastation across individual countries. Economic losses from disasters may reach massive proportions (Figure 5.4). In Dominica, for instance, the 2015 floods cost an equivalent of 96 percent of GDP; in Grenada, the damage from the 2004 hurricane amounted to 200 percent of GDP; and the 1998 storms in St. Kitts and Nevis cost more than 100 percent of GDP. In 2016 alone, two major disasters with significant human and economic costs occurred: Hurricane Matthew (September–October 2016) was the costliest weather-related catastrophe, making landfall in Haiti, Cuba, and the Dominican Republic; an estimated 200,000 homes were damaged or destroyed; the official death toll reached 600; and the total economic loss amounted to $15 billion, only one-third of which was covered by insurance (Aon Benfield Analytics 2016). In 2016, Hurricane Earl also damaged portions of the Caribbean, Belize, and Mexico, with almost 70 people killed and 15,000 homes damaged.

Figure 5.4.Annual Average Disaster Damage, 1970–2016

(Percent of GDP)

Sources: EM-DAT; and IMF, World Economic Outlook.

Note: Data labels in figure use International Organization for Standardization (ISO) country codes.

Costly disasters in small states are also becoming more frequent (Figure 5.5, panel 1). Small states as a consolidated group experienced 511 disasters between 1950 and 2016, an average of about seven disasters each year (Figure 5.5, panel 2), compared with one disaster each year in eight countries with individual land areas similar to that of the combined small-states group. About half of these natural disasters in small states were in the Caribbean, with multiple disasters occurring in each country within a given year. Climate change is expected to exacerbate these effects by increasing the frequency and severity of natural disasters, notably through its impact on sea level and damage to biodiversity, agricultural and coastal areas, housing, and infrastructure that the tourism-based economies in particular rely on heavily. The impact of more frequent and costly natural disasters on the Caribbean economies can be substantial, including lower economic growth and worsening fiscal and external balances, as well as the implications for poverty and social welfare, with the most vulnerable populations particularly at risk (LaFramboise and Loko 2012).

Figure 5.5.Occurrence of Natural Disasters in the Caribbean

Source: EM-DAT.

The Macroeconomic Impact of Natural Disasters

Natural disasters can be considered an extreme supply shock with potentially large and long-lasting macroeconomic effects. As IMF (2016a) and LaFramboise and Loko (2012) explain, the effects typically manifest themselves in three forms: (1) direct costs from the immediate loss of physical and human capital and destruction of infrastructure and property; (2) indirect, near-term loss of income from the disruption of economic activity in the public and private sectors, and costs incurred as individuals and businesses work around disruptions; and (3) recovery, with rebuilding and upgrading of infrastructure and replacement of damaged goods providing a temporary boost in activity and employment. The indirect impacts can spread throughout the economy over time and affect investment, growth, and fiscal and external accounts. The debt-to-GDP ratio can rise as the deterioration of the fiscal balance results in further debt accumulation and as growth slows. Periodic destruction of part of a country’s productive assets acts as an implicit tax on capital and labor, deters investment, and lowers productivity and living standards on a sustained basis.

The Caribbean economies are highly vulnerable to these effects. An IMF study found five Caribbean countries at extreme risk of natural disasters (Grenada, Belize, St. Lucia, Dominica, St. Vincent and the Grenadines) and two countries (Antigua and Barbuda, St. Kitts and Nevis) at high risk, with vulnerability measured with respect to disaster frequency and effects of disasters (IMF 2016a). Belize has also been found highly vulnerable to climate change, with vulnerability assessed using an exposure index based on the analysis of the Intergovernmental Panel on Climate Change. Antigua and Barbuda and St. Kitts and Nevis have been found to be vulnerable to a rise in sea level. This vulnerability results from a large share of the population living in high-risk areas with weak infrastructure, greater reliance on sectors that depend directly on weather (for example, agriculture, tourism), and limited capacity and resources to manage risk and build resilience (LaFramboise and Loko 2012).

The existing literature summarized in IMF 2016a broadly supports the view that natural disasters have adverse effects on key macroeconomic outcomes. Small states are disproportionately affected because of their more frequent exposure:

  • Natural disasters have a clear temporary impact on growth, though evidence on underlying long-term growth is mixed. Several studies point to significant negative short-term growth effects because damage to physical assets and commercial and financial infrastructure results in forgone production in the immediate aftermath of the disaster (Raddatz 2007; Noy 2009; Acevedo 2014; Cabezon and others 2015). Over a longer period, Loayza and others (2009) find reconstruction spending to have a positive impact on growth following small disasters, whereas several studies find a significant negative medium-term impact on growth following large shocks.2 Event studies support the claim that hurricanes result in a jump in unemployment in the short term, followed by reversal to the baseline (Ewing and Kruse 2002). Cavallo and Noy (2010) find no significant long-term impact, while Cabezon and others (2015) find that for the Pacific islands, trend growth during 1980–2014 was 0.7 percentage point lower than it would have been without natural disasters.
  • Fiscal balances tend to be adversely affected, but the extent of the deterioration typically depends on how governments respond to the disaster (LaFramboise and Loko 2012). The adverse impact on short-term activity tends to weaken the tax base and create higher volatility for tax revenue (see Cabezon and others 2015 for disaster-prone Pacific small states). Spending also tends to rise with relief and recovery programs.3 Resulting fiscal imbalances worsen fiscal sustainability depending on how recovery costs are financed. More developed financial systems, with high rates of insurance penetration, have been found to limit output losses and expansion of fiscal deficits (Melecky and Raddatz 2011). In the absence of deep financial markets, disasters have been found to result in higher public debt (see, for example, Acevedo 2014 for the Caribbean).4 Countries with deficits financed mostly with grants and donor support have adjusted more quickly (LaFramboise and Loko 2012).
  • Natural disasters also worsen external balances. Damage to production and transportation capacity can reduce exports. In the short term, imports could decline with reduced economic activity, but may rise thereafter, supported by disaster relief and recovery programs. On balance, the trade balance could deteriorate (Rasmussen 2004; Cabezon and others 2015). External current accounts often deteriorate, although other elements of the balance of payments could offset the deterioration, including increased international aid and remittances in the short term (Bluedorn 2005), or insurance company payment inflows for damage insured or reinsured abroad (LaFramboise and Loko 2012).
  • Natural disasters typically have a disproportionate impact on the poor. In developing countries and small states, low-income communities tend to live in the most vulnerable areas amid weak housing standards (World Bank 2003, 2016), and disasters can exacerbate social conditions. These communities typically have limited access to credit or insurance to help mitigate shocks (IMF 2003), and selling limited physical capital by the poor after disasters (including selling livestock to fund consumption) can lead to a long-term decline in productive capacity, reinforcing the vulnerabilities (LaFramboise and Loko 2012). Increased social spending by the government targeted to the most vulnerable populations, in turn, has fiscal implications.

The Caribbean Experience

An event analysis of 12 Caribbean countries broadly supports the findings of the previous studies, in that natural disasters have been associated with adverse effects on key macroeconomic outcomes. An examination of the disasters that had the largest damage-to-GDP ratios over the period 1950–2016 suggests that most countries experienced a decline in growth in the year of the disaster, but recovered in the subsequent year. Fiscal deficits also increased in the year of the disaster or subsequently in seven of the 12 countries. Debt-to-GDP ratios surged, and in some countries (The Bahamas, Barbados, Belize, St. Kitts and Nevis, St. Lucia, St. Vincent and the Grenadines) the disaster initiated an upward debt path that continued in subsequent years. External current account balances also deteriorated following disasters in most countries. The evolution of key macroeconomic variables around the very frequent natural disasters in some Caribbean countries (for example, The Bahamas and Jamaica) suggests that exposure to frequent disasters may be one of the key driving factors that interrupt a country’s efforts to sustain high rates of growth and improve fiscal balances, resulting, in turn, in gradually rising debt levels (Annex Figure 5.1.1).

Recent research on impediments to growth and strong fiscal performance in the Caribbean supports this possibility (Chamon and others, forthcoming). Policy-related structural challenges, including high exposure to natural disasters, explain the bulk of growth underperformance of the tourism-intensive Caribbean economies, along with other weaknesses, such as insufficient trade integration, gaps in human capital, crime, public indebtedness, ease of doing business, and financial strains. Addressing the various structural challenges to growth could provide important growth gains. The analysis suggests, for example, that reducing disaster damage by one-half could lead to significant growth gains for Dominica, Grenada, and St. Kitts and Nevis (about 1 percentage point higher GDP growth compared with baseline growth). These growth gains, in turn, could help break the negative debt-growth cycle and improve debt dynamics.

Climate change is expected to exacerbate the impact of natural disasters by making costly disasters increasingly more frequent and severe. Climate change increases the probability of large natural disasters (tropical storms) and raises mean damage (Acevedo 2016). Risks from sea-level rise and increased temperatures can affect growth through output losses in climate-sensitive sectors (such as forestry, tourism, agriculture, and coastal real estate) and through ecosystem disruption, damage to health, and water and food security risks, all with implications for long-term potential growth. Sea-level rise raises the risk of storm surges, tropical cyclones, and tsunamis, as well as the risk of persistent flooding and coastal erosion, affecting livelihoods, infrastructure, and habitability and posing a significant risk to growth and fiscal sustainability in tourism-dependent economies.5 Stressed ecosystems could exacerbate poverty resulting from food insecurity, loss of productive assets, and limited savings (Hallegatte and others 2015).6

The Policy Response

Differences in how natural disasters affect countries may reflect initial economic conditions and the country’s structural characteristics and institutions. Institutions affect the efficiency of public intervention following disasters or have an indirect impact by shaping the private sector response. Higher literacy rates, greater financial sector depth, and a high degree of trade openness increase governments’ ability to mobilize resources for reconstruction, mitigate the impact of the shock, and contain spillovers on the economy (Noy 2009). Economic diversification and availability of fiscal space to conduct countercyclical policy can also affect the response and overall economic cost. Similarly, countries with large reserve buffers and access to domestic credit, but with less open capital accounts, are better able to cope with disasters. These messages have clear implications for how countries can better cope with natural disasters and climate change risks.

More specifically, countries can adopt policies that help reduce the human and economic costs of disasters and climate change, and build resilience to future shocks. To that end, public policies can focus on better preparation, mitigation, and response and explicitly build disaster and climate change risks into policy frameworks, including in the design of budgets, medium-term fiscal frameworks, public investment planning, debt and asset management policies, financial regulation and oversight, crisis management, and contingency planning. A range of approaches is needed to manage the risks both before disaster strikes and in the aftermath.

Managing Risk Beforehand7

Identifying and assessing risks is the key starting point in managing disaster risk. Systems should be built to recognize the risks, assess their likelihood and potential impacts on macroeconomic outcomes and financial stability, and evaluate key vulnerabilities (for example, vulnerable infrastructure, communities, institutions, and populations). Where such risks are deemed high, countries should proactively improve the design of domestic policies to address the deficiencies and integrate these policies into investment, debt, and financial management frameworks. Governments, for instance, could prepare fiscal risk statements about the likelihood and potential impact of the risks and how they plan to manage the potential fiscal exposure to such disasters, which could, in turn, guide budget discussions and public financial management frameworks.

Reducing risk and preparing for it can be more effective than responding after the disaster strikes. Countries should invest in risk reduction, including by providing risk maps for high-risk areas and organizing information campaigns to raise risk awareness; setting up early-warning systems; implementing targeted public infrastructure projects (such as building seawalls along coastlines and maintaining and reinforcing roads and bridges); enforcing land use and zoning rules, building codes, and retrofitting requirements to reduce exposure to disaster damage; and providing incentives to encourage private sector investment in risk reduction (for example, through well-targeted subsidies for retrofitting properties or investing in drought-resilient crops).8 Despite high returns to doing so (Figure 5.6)—potential benefits outweigh the costs—countries tend to underinvest in disaster risk reduction and prevention. Such underinvestment reflects a number of obstacles that public policy will need to address, ranging from moral hazard (given the typical availability of ex post disaster funding) to capacity, information, or resource constraints in identifying, assessing, and managing risks, to political economy problems.

Figure 5.6.Does It Pay to Prepare and Prevent?

Source: Reproduced from World Bank 2013b.

  • Capacity, information, and resource obstacles. Insufficient resources and capacity make it difficult for developing countries, particularly the smaller Caribbean economies, to identify and assess disaster risks and take precautionary actions.9 Similarly, shortfalls in funding the cost of climate change mitigation and adaptation have been an obstacle to taking action. Despite the available information on the evidence of climate change and disasters, individuals and governments continue to overlook their potential exposure to what they view as rare or distant events, underestimate the potential cost of inaction, and fail to take preventive action or insure against the events (Otker-Robe 2014; World Bank 2013b). Small-probability but high-impact risks are often ignored in the face of short-term challenges or priorities, resulting in underinvestment in preventive steps.
  • Moral hazard and political economy factors. Availability of ex post disaster financing can create moral hazard and undermine incentives for prevention and preparation, including incentives to invest in warning systems or enforce strict zoning and building regulations in disaster-prone areas, or for individuals to obtain insurance or avoid settling in when other alternatives are available (Clarke and Dercon 2016; IMF 2016b; World Bank 2013b). For governments, responding to disasters “after the event” may be judged to be more rewarding politically, compared with investing in generally costly hazard prevention and risk reduction, the rewards for which are less visible until disasters strike. Acting to reduce risk and prepare may also be undermined by political cycles, since preventive investments may span multiple administrations and make ownership difficult to attribute.

Public policy at national, regional, and international levels can help address the obstacles to effective management of disaster and climate change risks. Policy could aim to narrow existing information gaps and address behavioral biases, including through more systematic, frequent, and targeted dissemination of key information and best practices to build longer-term perspectives on rare, high-impact, or distant risks and raise awareness of the dangers of inaction. The international community could support capacity building and risk management actions to design contingency plans; set up monitoring, early-warning, and communication systems; develop insurance and hedging markets and make them more accessible to facilitate private sector risk-sharing solutions; and help countries diversify their economies to lessen the economic impact of disasters. Financing could be allocated to areas that build resilience and reduce vulnerabilities, and to those most exposed to shocks. Rewarding preparation and risk reduction by reducing premiums, making financing contingent on risk management, and providing technical assistance to build risk management capacity can limit moral hazard and encourage preparation that, over time, should reduce the need for future support (Otker-Robe 2014; World Bank 2013b).

Investing in risk mitigation is essential where risks cannot be prevented or reduced. Given the increasing cost and frequency of natural disasters, Caribbean governments can reduce their fiscal exposure by arranging for disaster financing before the event through a combination of (1) self-insurance (by building fiscal buffers or contingency funds), (2) risk-transfer arrangements (through catastrophe insurance or other capital market options, such as issuing catastrophe bonds, or participating in regional risk-sharing solutions), and (3) contingency financing.

  • Building fiscal buffers provides self-insurance (IMF 2016a, 2016b). The appropriate size of the buffer can be established based on an assessment of disaster risks and their frequency and cost (Guerson 2016). Once the buffer is established, fiscal policy needs to ensure accumulation of savings, including through additional revenue measures or reduced spending if the buffer falls short, and a timeline for policy adjustment. Buffers can be accumulated in various ways and at various paces, and can be linked to medium-term fiscal objectives, considering the associated costs and benefits, especially when priority spending needs to be cut to boost savings and build buffers (IMF 2016a). “Looking through the cycle” may be needed in conducting fiscal policy, that is, a stronger fiscal stance may be needed in nondisaster years to accumulate buffers to offset the adverse impact when disasters hit. Fiscal rules can provide the discipline needed to sustain buffers and could be accompanied by an escape clause that allows for larger fiscal deficits as part of the response to natural disasters.10 Debt-sustainability assessments should prevent an excessive rise in the overall debt burden and ensure a sustained period of strong fiscal performance to reduce debt ratios in disaster-prone countries.
  • Contingent lines of credit can also help reduce ex ante disaster financing uncertainty. Ex ante financing agreements with bilateral, multilateral, and commercial creditors can be mobilized in the event of a disaster. For instance, at the bilateral level, the Marshall Islands, Micronesia, and Palau benefit from compacts with the United States offering access to emergency support from relevant U.S. agencies. At the multilateral level, the World Bank’s Catastrophe Draw-Down Option offers a government immediate access to funds after a natural disaster, a time when liquidity constraints are usually highest.11 Similarly, the IMF’s emergency financing facilities, such as the Rapid Credit Facility and the Rapid Financing Instrument, are important sources of swift postdisaster liquidity support for small developing countries (IMF 2016a, 2017).
  • Disaster risk insurance and related hedging tools also help protect governments from the economic burden of disasters and increase the capacity to respond. Governments can insure public assets and encourage insurance of private assets to reduce uncertainties associated with direct exposure to disaster risks. Encouraging private property insurance also reduces the risk that the public sector will be called on to cover private losses. Countries with more private and public insurance penetration experience lower output and income losses from disasters (Melecky and Raddatz 2011; von Peter, von Dahlen, and Saxena 2012; Munich Re 2013; Standard and Poor’s 2015), but insurance coverage remains low globally (Swiss Re 2013; Aon Benfield Analytics 2016). Traditional indemnity insurance of physical assets is being used in a number of countries, although it is not widespread in small Caribbean economies given the high cost, especially where markets are underdeveloped and competition is limited (for example, in Belize and Grenada, insurance covered 4.5 percent of total damage in a recent large disaster; IMF 2016a).
  • Innovative approaches for sharing natural disaster risks have also emerged over the past decade and could provide relief to governments in managing disaster risks. Parametric insurance, effectively an options contract, pays out in the event of a disaster that exceeds a pre-specified severity; triggers for payout are defined by storm, flood, or earthquake intensity and measured based on third-party data. While parametric insurance provides a quick relief, its cost can be high in a developing market. Economies of scale have been achieved by pooling cover at regional levels.12 Catastrophe bonds that transfer the risk of a disaster to markets in exchange for a generous coupon payment allow the issuer to forgo repayment of the bond principal if a major disaster occurs. The forgone repayment releases resources from debt service to finance disaster response.13 The market for catastrophe bonds is still developing, with challenges including the need to build investor expertise and confidence in these instruments and high cost.

Well-developed and well-functioning financial systems and markets are crucial to facilitating mitigation of natural disaster and climate change risks at affordable cost. More developed financial systems can enable a high rate of insurance penetration and offer hedging instruments, and help limit output losses and expansion of fiscal deficits (Melecky and Raddatz 2011). Access to credit, market insurance, and hedging products can provide the needed resources when disasters strike, helping mitigate the adverse effects on the private sector and reducing the burden on governments in reconstruction and recovery (Farid and others 2016; Fabrizio and others 2015). Well-developed financial markets can also help finance climate-change-risk adaptation efforts by funding projects that build resilience (for example, building floodgates, dykes, and other infrastructure, and investing in drought-resistant crops).

Managing Postdisaster Risk

Building disaster response frameworks and contingency plans is crucial when risks cannot be averted or mitigated. Contingency plans are essential, since failure to plan can hamper the effectiveness of postdisaster intervention. Plans could focus on addressing the key risks and vulnerabilities (for example, emergency housing, compensation for the homeless, and restoration of key public infrastructure if hurricanes, cyclones, or earthquakes are the main risk, and food security and income support for farmers if drought is a key risk (Clarke and Dercon 2016; IMF 2016a). Putting in place necessary institutional frameworks could also provide spending flexibility for coping with natural disasters (for example, by allowing the government to exceed spending limits up to a defined amount in the event of a formally declared natural disaster, escape clauses in fiscal responsibility laws [as in Grenada] to allow the government to exceed targets if there were to be a major natural disaster, provision in the annual budget law for shifting resources following a major disaster, and setting up contingency space in the budget to cope with emergency needs).

Given the degree of exposure to disaster risk, policymakers could choose a mix of instruments to finance their contingent liability at the lowest economic opportunity cost. IMF (2016a) suggests that adopting the World Bank’s risk-layered framework for optimizing disaster financing could be useful in this context (Table 5.2):

  • Small but unpredictable financing needs can be met using self-insurance—either by reallocating spending or drawing down available government deposits.
  • Moderate-sized disasters will generate financing needs that typically exceed buffers available from self-insurance, and will require access to external resources through contingent arrangements and risk-transfer options in which a third party takes over a portion of disaster-related financial risks in exchange for a fee or premium.
  • For the largest disasters for which large-scale insurance is not cost-effective, sovereign catastrophe bonds can enable some risk transfer, though debt sustainability considerations may prevent large-scale use of borrowed resources, and there may be little alternative but to depend on grants and humanitarian assistance, where available.
Table 5.2.Disaster Financing Risk-Layering Model
Probability or Frequency of Event (size of shock)Ex Ante FinancingEx Post Financing
5 Percent or ≤ 20 Years

(≤ 3 Percent of GDP)
Budgetary reservesEmergency budget allocations
3.33 Percent or ≤ 20–30 Years

(≤ 5 Percent of GDP)
Contingent loansEmergency loans
1 Percent or ≤ 30–100 Years

(≥ 5 Percent of GDP)
Insurance and reinsurance
0.5 Percent or ≤ 100–200 Years

(≥ 5 Percent of GDP)
Catastrophe bondsGrants and humanitarian aid
Below 0.5 Percent or ≤ 200 Years

(≥ 5 Percent of GDP)
Global partnerships for exogenous shocks and pandemicsGrants and humanitarian aid
Source: Reproduced from IMF 2016a, based on Clarke and Deacon 2016.
Source: Reproduced from IMF 2016a, based on Clarke and Deacon 2016.

Summary and Conclusions

The Caribbean economies face formidable fiscal challenges, as evidenced by high levels of fiscal deficits and debt; many countries are trapped in a vicious circle of high-debt, low-growth performance. An important factor underlying this adverse feedback loop is the vulnerability of these countries to frequent and costly natural disasters. Since 1950, the region has been hit by hundreds of natural disasters (on average, seven disasters per year) that have killed hundreds of thousands of people and affected millions more. The economic impact of natural disasters is substantial; annual damage accounts for 40 percent of global damage, averaging 2.4 percent of GDP. Caribbean small states have suffered more damage at greater frequency than both other small and larger states. Climate change is expected to exacerbate these effects by increasing the frequency and severity of natural disasters, affecting the livelihood of the populations, and harming the essential assets their insufficiently diversified economies rely on.

Natural disasters have adverse effects on key macroeconomic outcomes. Most countries experience an immediate decline in growth in the year of the disaster, though generally recover in the subsequent year except for in the case of disasters. Fiscal deficits typically increase in the year of the disaster or subsequently, and debt-to-GDP ratios surge, in some countries initiating an upward path that continues for several years. External current account balances deteriorate in most cases. Exposure to frequent disasters may repeatedly interrupt a country’s efforts to achieve high and sustainable rates of growth and improve fiscal balances and debt. Availability of aid, as well as more developed financial systems with high rates of insurance penetration, can help limit output losses and expansion of fiscal deficits and public debt.

Countries can adopt policies that help reduce the human and economic cost of disasters and climate change, and build resilience to future shocks. In this context, public policies can focus on better preparation, mitigation, and response and explicitly build disaster and climate change risks into their policy frameworks. Policies can address the obstacles to proactive management of disaster risk through risk reduction and preparation, including by reducing constraints on capacity, information, or resources; providing appropriate incentives; and countering political economy constraints. Where risks cannot be averted or reduced, risk mitigation using a combination of self-insurance, risk-transfer arrangements, and contingency financing is essential.

Policy at the regional and international levels could support countries’ efforts by providing capacity building, tools for risk management, and financing. Technical assistance can help with designing contingency plans when risks cannot be prevented or mitigated; setting up monitoring, early-warning, and communication systems; developing insurance, financial, and hedging markets and making them more accessible to facilitate private sector risk-sharing solutions; and assisting countries with diversifying their economies to lessen the economic impact of disasters. Financing could target areas that reduce vulnerabilities and build resilience, and reward preparation and risk reduction. Given the degree of exposure to disaster risk, policymakers could choose a mix of instruments that finance their contingent liability at the lowest economic opportunity cost.

Annex 5.1

Annex Figure 5.1.1.The Caribbean: Macroeconomic Effects of Natural Disasters before and after a Disaster Event

Sources: EM-DAT; IMF, World Economic Outlook; and IMF staff calculations.

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1In the commonly used global Emergency Events Database (EM-DAT), natural disasters are defined to include geophysical (earthquakes, volcanic activity, mass movement), meteorological (extreme temperature, fogs, storms), hydrological (foods, landslides, wave action), climatological (drought, wildfire), and biological (epidemic, insect infestation) events. EM-DAT covers disasters that involve at least 10 or more people reported killed, 100 or more people reported affected, a declaration of a state of emergency, or a call for international assistance.
2Major disasters reduce real GDP per capita by about 0.6 percent on average (larger impact of 1 percent for lower-income countries (Hochrainer 2009; LaFramboise and Loko 2012). Disasters also produce an estimated 0.7 percentage point drop in a country’s growth rate within the first year, on average, leading to a cumulative output loss, on average, of about 1.5 percent, in addition to the immediate direct losses (von Peter, von Dahlen, and Saxena 2012; LaFramboise and Loko 2012). The growth impact may differ across different types of disasters. Among climatic disasters, droughts have the largest average impact, with losses of 1 percent of GDP per capita and more than 2 percent per capita for lower-income countries (Raddatz 2009; Loayza and others 2009). In small island states, hurricanes have a larger estimated effect (on average, a 3 percent decline in GDP per capita) (Raddatz 2009).
3For middle- and upper-income countries, Melecky and Raddatz (2011) find that disasters boost expenditures by about 15 percent and lower revenues by about 10 percent, leading to an overall increase in budget deficits of 25 percent compared with initial levels.
4The fiscal impact of disasters may be understated, to the extent that aggregate spending data conceal a shift of resources toward disaster programs from other priorities.
5Some small island states and coastal countries (for example, Guyana and Suriname in the Caribbean) could lose 10 percent of GDP or more under high sea-level scenarios (see, for example, Dasgupta and others 2007; World Bank 2013a).
6For Caribbean small states, a one-meter sea-level rise by 2080 is projected to result in losses and damage of about 8 percent of projected GDP (Simpson and others 2010; IMF 2016b; Farid and others 2016).
7This section draws heavily on IMF 2016a, Otker-Robe 2014, and World Bank 2013b.
8For example, St. Lucia and St. Vincent and the Grenadines have enhanced disaster resilience through infrastructure projects, including more effective seawalls along urban coastlines, maintenance or reinforcement of bridges, and investments in urban resilience.
9During 2007–12, for example, insurance covered less than 20 percent of total disaster losses in developing countries, on average, compared with about 60 percent in North America, according to SwissRe. Insurance intake is still low in many parts of the world, covering about one-third of natural disaster losses (Aon Benfield Analytics 2016).
10To build resilience to natural disasters, Grenada negotiated the inclusion of natural disaster clauses in several debt-restructuring agreements that allow for a delay in debt service following a qualifying natural disaster and provide important cash flow relief if a natural disaster materializes. Grenada also mandated contingency financing for natural disasters, with the Fiscal Responsibility Law requiring 40 percent of proceeds from the citizenship-by-investment (CBI) program to be transferred into the National Transformation Fund and saved. St. Kitts and Nevis is also in the process of establishing a Growth and Resilience Fund; deposits accumulated from CBI inflows are to be used to respond to external shocks, including natural disasters.
11The Catastrophe Draw-Down Option is available only to middle-income countries. A number of countries have used this instrument, including Colombia, Costa Rica, Guatemala, Peru, the Philippines, and Sri Lanka (World Bank 2011).
12These include, for example, the Caribbean Catastrophe Risk Insurance Facility, supported by the World Bank; a similar facility created for Pacific countries—the Pacific Catastrophe Risk Insurance Pilot; and African Risk Capacity, an Africa insurance pool for droughts (with food risks to be added at a later date).
13Examples of such instruments include development, with collaboration with the World Bank, of a platform for a multicountry, multiperil catastrophe bond (the MultiCat Program with Mexico), which transfers risk to private investors and allows pooling of multiple risks to take advantage of diversification benefits (World Bank 2013a; Mahul and Cummins 2009; Mahul and Ghesquiere 2010).

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