Eastern Caribbean Currency Union: Selected Issues
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International Monetary Fund
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Publication Date:
27 Oct 2004
eISBN:
9781451811667
Language:
English
Keywords:
ISCR; CR; ECCU country; bank; current price; capital base; cost estimate; a number of capital market instrument; Natural disasters; Fiscal stance; Insurance; Personal income; Caribbean
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This Selected Issues paper on the Eastern Caribbean Currency Union (ECCU) underlies key features of business cycles. To obtain new measures of classical and growth cycles, simple rules were applied to date turning points in the classical business cycle, and a recently developed frequency domain filter was used to estimate the growth cycle. At the regional level, the ECCU countries are facing two shocks, i.e., the depreciation of the U.S. dollar and the depreciation of the Dominican Republic’s peso. The countries of the ECCU have experienced modest erosion in their price and nonprice competitiveness.

Abstract

This Selected Issues paper on the Eastern Caribbean Currency Union (ECCU) underlies key features of business cycles. To obtain new measures of classical and growth cycles, simple rules were applied to date turning points in the classical business cycle, and a recently developed frequency domain filter was used to estimate the growth cycle. At the regional level, the ECCU countries are facing two shocks, i.e., the depreciation of the U.S. dollar and the depreciation of the Dominican Republic’s peso. The countries of the ECCU have experienced modest erosion in their price and nonprice competitiveness.

II. Natural Disasters and their Macroeconomic Implications1

A. Introduction

1. Natural disasters have a substantial macroeconomic impact in many developing countries. 2 Tropical cyclones, floods, droughts, and other natural hazards may overwhelm countries’ resources and have disastrous outcomes. With little resilience to such events, developing countries are particularly vulnerable and have borne most of the disaster-related human cost. Within countries, the poor suffer most, as limited access to capital markets and insurance entail few possibilities for smoothing out losses. Large natural disasters have often led to a worsening of fiscal and external balances, and have sometimes triggered economic crises. Extreme weather events are becoming more frequent, which highlights the need for polices to better mitigate and respond to these occurrences.

2. The ECCU countries stand out as among the most hazard prone in the world, with a very high frequency of violent windstorms. A direct hit by a major hurricane, causing massive human suffering and widespread destruction, is almost certain to occur again in the future. Based on the experience since 1970, a large natural disaster, inflicting damage equivalent to more than 2 percent of the affected country’s GDP, can be expected to hit the region roughly once every two and a half years.

3. The high public debt levels in ECCU countries severely constrain their financial ability to respond to adverse shocks, making preparedness for natural disaster all the more important. Countries can substantially lessen their exposure by improving building practices and better response strategies can help reduce the severity of disasters. Nevertheless, natural disasters cannot be entirely avoided. This calls for generating public savings in good times to leave room for added expenditure when natural disasters occur. Increased use of market-insurance to address natural hazard risk would help, but there is also a need for increased self-insurance through the creation of contingency funds. However, given the high levels of debt and the fiscal problems in many countries, freeing resources to combat natural disasters is becoming increasingly difficult.

4. The remainder of this chapter is organized as follows. Section B presents an overview of the incidence of natural disasters, while Section C discusses their macroeconomic implications. Section D offers an outline of different strategies to mitigate the impact of natural disasters, and Section E summarizes the key findings.

B. The Incidence of Natural Disasters

5. Of the more than 6,000 natural disasters recorded since 1970, three-fourths of the events and 99 percent of the people affected were in developing countries. During 1970–2002, natural disasters are estimated to have affected more than five billion people and to have caused more than a trillion dollars in damage (Table II.1, Figure II.1, Figure II.2). About 40 percent of the damage occurred in developing countries, almost double their share in world GDP. The poor are often the primary victims of natural disasters, as they tend to live in high-risk areas, rely on a fragile low quality infrastructure, and engage in agriculture, which is particularly exposed to weather-related events (World Bank, 2003).

Table II.1.

Frequency and Impact of Natural Disasters, 1970–2002 1/

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

Based on EM-DAT (CRED, 2003), natural disasters are defined as events due to natural causes that caused 10 or more fatalities, affected 100 or more people, or resulted in a call for international assistance or the declaration of a state of emergency. The total number of affected is defined as people that have been injured, made homeless, or requiring immediate assistance during a period of emergency. Figures omit countries without at least one natural disaster associated with a cost estimate and/or missing information on GDP.

Average number affected each year in percent of population. Figures are unweighted averages across countries.

Average damage each year in percent of GDP. Figures are unweighted averages across countries.

Figure II.1.
Figure II.1.

Global Frequency and Impact of Natural Disasters. 1970-2002

Citation: IMF Staff Country Reports 2004, 335; 10.5089/9781451811667.002.A002

Source: EM-DAT; World Economic Outlook.
Figure II.2.
Figure II.2.

Cross-Country Frequency and Impact of Natural Disasters, 1970-2002

Citation: IMF Staff Country Reports 2004, 335; 10.5089/9781451811667.002.A002

Source: EM-DAT; World Economic Outlook.

6. Natural disasters are becoming more frequent and the overall cost is increasing even more rapidly. The total number of natural disasters recorded in the 1990s increased threefold compared to the 1970s, and estimated economic losses increased even more rapidly. These increases are partly the result of a build-up of infrastructure subject to potential damage, and an increased concentration of population in high-risk areas. While part of the higher number of recorded natural disasters is related to more comprehensive reporting, there is also a broad consensus that the frequency and intensity of extreme weather events have gone up and are likely to increase further during the twenty-first century (IPCC, 2001). This development is generally thought to be associated with the increase in mean global surface temperatures, which has lead to higher absorption of water vapor into the atmosphere.

7. Overall, the number of people affected by natural disasters appears to be growing at a somewhat slower pace than the economic damage. Indeed, in a majority of countries, the share of the population affected by natural disasters declined from the 1980s to the 1990s. As countries have become richer their capacity to withstand and respond to natural hazards appears to have improved. This likely reflects an increased institutional capacity, quality improvements in the housing stock and other relevant infrastructure, and a movement away from agriculture.

8. The negative impact of higher income on vulnerability to natural disasters is evident in cross-country regression analysis. Regressing the number of people affected by natural disasters on measures of the frequency of events, income, and the share of employment in agriculture produces coefficients with the expected signs, although the coefficient on agriculture is only just significant at the 10 percent level (Table II.2). Economic damage from natural disasters appears less strongly influenced by income levels, which presumably reflects that increased wealth also entails more assets subject to potential damage, and the role of agriculture in this case appears insignificant.3

Table II.2:

Determinants of Vulnerability to Natural Disaster, 1970-2002

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Note: OLS regressions based on 83 observations and including a constant (not shown). Figures in parentheses are standard deviations. “*”, “**”, and “***” indicate significance at, respectively, the 10, 5, and 1 percent level.

9. Situated in the so-called hurricane alley, the ECCU countries are highly exposed to natural disasters. The Eastern Caribbean is in the center of the Atlantic hurricane belt, and several of the countries are subject to potential volcanic eruptions. Typically occurring during the June–November period, windstorms have caused 34 of the 44 natural disasters recorded since 1970 in the six ECCU countries that are Fund members (Table II.3). On average, a natural disaster occurred once every four and a half years in each of the six countries. Not all these events were very large, however. Considering only incidents that affected at least 2 percent of a country’s population or inflicted damage of at least 2 percent of GDP, EM-DAT figures point to such events occurring in the individual countries once every nine years or somewhere in the region once every two and a half years. Among these large disasters, the median number of affected amounted to 9 percent of the country’s population and the median value of damage was equivalent to 14 percent of the country’s annual GDP.

Table II.3.

Natural Disasters in ECCU Countries, 1970–2002

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Sources: EM-DAT; World Economic Outlook and Fund staff estimates.

10. Some events have been truly devastating, affecting the population of an entire country and causing damage exceeding 100 percent of GDP. For example, in 1979 Hurricane David hit Dominica with winds in excess of 130mph, killing 42 people, damaging 95 percent and completely destroying 12 percent of buildings, damaging or destroying the entire banana crop and 75 percent of forests, rendering virtually the entire population homeless, and leading to the temporary exodus of about a quarter of the population (Benson et al., 2001). Consequently, GDP plummeted by 17 percent, central government current expenditure increased by 31 percent with capital expenditure increasing even more rapidly, and the fiscal deficit increased from 3.1 percent of GDP in 1978 to 8.1 percent in 1981 despite a sizeable increase in foreign grant receipts.

11. By several measures—frequency, population affected, and value of damage—the ECCU countries are among the most disaster prone in the world (Table II.4). 4,5 The relative proneness of countries to natural disaster can be quantified in several ways, with different measures highlighting different aspects of risk and vulnerability. When comparing the number of natural disasters during 1970–2002 to land area all six ECCU countries rank among the top-10 most disaster prone in the world. By this measure, they were more than 12 times as exposed as the average country. The incidence is only slightly less severe when one compares the number of disasters to population, with all but one of the six countries ranking in the top 10. On average, a cumulative 85 percent of the ECCU population was affected during the period, compared to a worldwide average of 62 percent. The average cumulative damage was equivalent to 66 percent of annual GDP, compared to a worldwide average of 21 percent.

Table II.4.

The Incidence of Natural Disasters in the ECCU Compared to the Rest of the World, 1970–2002

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Sources: EM-DAT for data on natural disasters, including estimates of the number of people affected and the value of damage; World Development Indicators for data on land size; World Economic Outlook for data on GDP and population. Note: The sample contains 150 countries after omitting countries without at least one natural disaster associated with a cost estimate and/or missing information on GDP (24 advanced economies, 15 Caribbean countries, and 111 other developing countries). Simple unweighted averages are used for country groupings. Rankings are in descending order, with “1” indicating the most exposed to natural disaster.

In 1000s of US$ in 2002.

12. The higher vulnerability of ECCU countries to natural disasters by measures of frequency than by measures of the severity of impact is consistent with the tendency for countries to become more resilient as they become richer. Average per capita GDP in the six ECCU countries was US$5,500 in 2002, compared to US$1,400 and US$1,900 for the top-20 most vulnerable countries according to, respectively, the number affected in percent of the population and the damage incurred in percent of GDP. The relatively high level of income in ECCU countries is probably an important mitigating factor for the frequent natural disasters.

C. The Macroeconomic Implications of Natural Disasters

13. As illustrated in the previous section, natural disasters are associated with substantial costs. In principle, one can distinguish between several sources of loss. The direct cost of a natural disaster involves loss of assets such as crops, raw materials, and buildings. In addition, there are costs of disruption to normal economic activity caused by disturbance to supply chains and damage to production facilities. Finally, these impacts may cause spillovers at the macroeconomic level, as fiscal and external pressures can lead to imbalances that spark economic crises and increased incidence of poverty can create social unrest. The estimates of damage reported above generally only seek to capture the direct cost (usually excluding the value of lost human capital) and the most tangible sources of indirect cost. It is therefore useful to examine the broader impact.

14. Natural disasters have a discernable macroeconomic impact in the first few years following an event. In general, the short-term impact is seen in a contraction of economic output and a worsening of external and fiscal balances, with the impact somewhat softened by an increase in transfers from abroad. The long-term impact is more difficult to assess, but appears to be associated with an increase in the volatility of income and consumption.

Short- and Medium-Term Impact

15. Cross-country studies of the economic effects of natural disasters reveal that these are typically associated with:

  • An immediate contraction in economic output. While there is substantial variation, evidence suggests that large natural disasters are usually accompanied by a reduction in same-year GDP growth, with the impact ranging from very small (e.g., 1994 flood and drought in Cambodia) up to 20 percentage points or more (e.g., Dominica in 1979). Looking at Latin America and the Caribbean, Auffret (2003 a) considers 16 natural disasters and finds that 1 percent of GDP in direct damage reduced GDP growth by half of 1 percent in the same year; Charvériat (2000) analyzes 35 events with a median damage of 3 percent of GDP and finds that same-year GDP growth fell in 28 cases, with an overall median reduction of 1.7 percent; and Crowards (2000b) finds that same-year GDP growth fell by an average of 3.1 percent following 21 major natural disasters. In general, the effect of the disruption to economic activity is offset by spending on emergency relief and reconstruction, and one would therefore expect the reduction in GDP growth to be temporary, as indeed appears to be the typical pattern, with GDP growth usually rebounding in the year after the event.

  • A worsening of external balances. Natural disasters typically result in an increase in imports, for reconstruction materials and to compensate for lost production, and exports tend to suffer. For example, ECLAC (2000) considers 42 large natural disasters in Latin America and the Caribbean and finds that these were, on average, associated with a deterioration in the balance of payments by an amount equal to about one-third of the estimated damage; and Crowards (2000b) finds that 21 major natural disasters led to an average worsening of the trade balance by about half and lasting for three years due to an increase in import growth and, to a lesser extent, a reduction in export growth. A country’s dependence on agricultural exports appears to be an important indicator of the magnitude of the response, highlighting the vulnerability of this sector (Benson et al., 2001).

  • A deterioration in fiscal balances. While significant relationships are difficult to establish, natural disasters can put substantial pressure on public finances. Emergency assistance and reconstruction efforts call for higher government expenditure. At the same time, tax revenue may suffer from the decline in economic activity, especially if agricultural exports are a major source of tax revenue. Consequently, the result is usually a widening of the deficit. For example, IMF (2003) finds that five large exogenous shocks in Africa were associated with same-year increases in fiscal deficits of up to 3 percent of GDP. However, in many cases natural disasters appear to have had very little impact on fiscal balances, which may reflect that countries are constrained by existing expenditure envelopes that limit their responses to reallocations (Benson and Clay, 2003a).

  • An increase in poverty. Natural disasters tend to have a disproportional impact on the poorer segments of the population. Low-income households tend to settle in the most vulnerable areas and rely on poorly constructed housing (World Bank, 2003). In addition, the poor are generally less able to cushion the impact on consumption of disruptions to income owing to small savings and limited access to credit (IMF, 2003). While there thus appears to be a significant increase in poverty following a natural disaster, it is unclear how quickly affected households can recover.

16. The macroeconomic implications of 12 large natural disasters occurring in the ECCU since 1970 conform to the general pattern and are by some measures more severe than in other regions of the world (Figure II.3).6 In the year of the event, the median reduction in real GDP growth was 2.2 percent, reflecting a large decline in agricultural production and an offsetting increase in investment. Exports declined and imports increased, resulting in a staggering 10.8 percent of GDP median increase in the current account deficit, with a gradual recovery in the following years. The impact on external balances appears substantially larger than in other countries, possibly reflecting the very high openness of the ECCU economies. While comprehensive historical data on tourism are not available for the period, the impact on exports suggests that tourism receipts suffered, as this is by far the largest source of foreign-currency earnings in the ECCU, and as hurricanes can cause substantial damage to beaches, coral reefs, and other relevant assets.7 The impact on the central government was less clear, with a large variation in outcomes. Nevertheless, the tendency appears to have been a marked increase in expenditure and a small reduction in total revenue (including grants) despite an increase in inflows of official assistance and aid. As a result, the median public debt-to-GDP ratio increased sharply by a cumulative 6.5 percentage points over three years.

Figure II.3.
Figure II.3.

Median Impact of 12 Large Natural Disasters in the ECCU, 1970-02

Citation: IMF Staff Country Reports 2004, 335; 10.5089/9781451811667.002.A002

Source: World Economic Outlook, World Development Indicators, and Fund Staff Calculations.Note: Includes the 12 natural disasters with estimated damages exceeding 2 percent of GDP shown in Table II.3 (the 1987 hurricane and flood in St Vincent and the Grenadines are treated as a single event). Bars indicate the range between the first and the third quartile of the distribution.1/ Excludes Grenada 1975 and St. Lucia 1980.2/ Excludes Grenada 1975 and 1980.3/ Excludes Antigua and Barbuda 1989, Dominica 1979, and St. Lucia 1980.

Long-Term Impact

17. Natural disasters can affect long-term outcomes through a number of channels, including through environmental damage on agriculture, fishing, and forestry (ECLAC, 2000). Other effects are more difficult to quantify, but are likely to occur in some situations. For example, destruction of schools may have a long-lasting negative impact on the stock of human capital; reconstruction efforts may crowd out productive public spending, reducing the economic growth rate and the future tax base; increased indebtedness may raise the rate of interest, reducing future investment; and the worsening of fiscal and external balances may trigger inflation, loss of confidence, capital flight, and bank and/or balance of payments crises.8

18. Evidence of a long-term impact on income levels from natural disasters is inconclusive. There has been little empirical analysis of the impact of natural disasters on long-term outcomes, and drawing firm conclusions is difficult. As shown in Table II.5, different measures of disaster proneness do not reveal any persistently significant rank correlations with main macroeconomic indicators, and significant correlations sometimes appear with an unexpected sign. Nevertheless, as one would expect, the rank correlations seem to suggest that proneness to natural disasters: is associated with low per capita income; high volatility of income, consumption, and fiscal balances; a large agricultural sector; and a low investment ratio. Contrary to what one might expect, the number of recorded events divided by land area appears positively correlated with GDP growth. While the World Bank (2003) finds that the evidence of an impact on growth is weak, a positive correlation can be rationalized by arguments such as: natural disasters help initiate adoption of painful but beneficial reforms, or lead to the replacement of capital with newer and more productive varieties (Easterly and Kraay, 2000). However, the positive correlation contrasts with findings described in Benson and Clay (2003b), which suggest that hazard proneness has a negative impact on economic growth.

Table II.5:

Correlations Between Measures of Proneness to Natural Disasters and Selected Macroeconomic Variables, 1970–2002

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Note: Bolded figures indicate that the rank correlations are significant at the 5 percent level (one-sided test). A positive correlation suggests that higher values of the variable are associated with an increased proneness to natural disaster, as reflected by the four measures in the first column. Sources: International Financial Statistics; World Economic Outlook; and World Development Indicators. Variables: freql, number of events divided by country land mea;freq2, number of events divided by country population; affect, percentage of population affected; damage, damage in percent of annual GDP; lpppc, average level of current price GDP per capita at PPP exchange rate; lgdpc, average level of current price GDP in USD per capita; ggdpc, average growth rate of current price GDP in USD per capita; grgdp, average growth rate of constant price GDP; vrgdp, standard deviation of constant price GDP; vcons, standard deviation of total consumption in US dollars; vgovbp, standard deviation of central government balance in percent of GDP; agri, share of agriculture in GDP; tiratio, average ratio of total investment to GDP

19. The tendency of natural disasters to increase volatility appears more solid, although the direct effect may be relatively modest. The Caribbean suffers from a very high level of consumption volatility, impacting negatively on welfare given people’s desire for consumption smoothing. This could plausibly be the result of the region’s proneness to natural disasters, as suggested by the finding of generally positive rank correlations between the measures of proneness to natural disaster and measures of volatility. However, using cross-country regression analysis, the World Bank (2003) finds that, while natural disasters have a significant impact on income volatility in the Caribbean region, the direct impact on consumption volatility is statistically insignificant. Also, although there is substantial variation between countries, income volatility in the Caribbean is not especially high (Table II.6).9 This suggests that the impact of natural disasters on aggregate volatility is not a dominating determinant, which is perhaps not so surprising given that large events are relatively rare occurrences. In addition, the very high degree of consumption volatility in the Caribbean probably has less to do with proneness to natural disaster than it has to do with inadequate mechanisms for consumption smoothing—in particular a dearth of credit and insurance to compensate for temporary losses.10 This is likely to be a particularly significant problem for the poor, who have fewer liquid assets and less insurance coverage.

Table II.6.

Volatility in Income and Consumption Growth, 1970–99

(Standard deviation of growth rates in percent)

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Source: World Bank (2003).

D. Mitigating Natural Disasters

20. The cost of natural disasters to individual countries can be substantially mitigated. Insurance and capital markets can provide compensation for loss of capital and income, alleviating the damage to household and government balance sheets, and reducing the immediate impact on consumption possibilities. Good building practices and other precautionary arrangements can lessen the impact of disasters in the first place. Unfortunately, these mechanisms function poorly in many of the countries most vulnerable to natural disasters, including the ECCU countries.

Coping With Risk: The Role of Insurance and Credit Markets

21. Insurance markets can reduce the negative impact of natural disasters by spreading the burden over space and time. The insurance market is mainly international, with local insurers re-insuring part of their exposure with larger, often global, companies. However, the market for natural hazard insurance does not operate very smoothly and is limited in scope. As described in Pollner (2001), natural disasters are ‘high severity, low frequency’ events that are more difficult to manage for insurance companies than the ‘low severity, high frequency’ risk that they prefer to cover. In addition, objective information on damage and risks is difficult to obtain. Consequently, the market for catastrophe risk insurance is well known to be inefficient, with high price of coverage, excessive volatility, and insufficient pooling of risk. A more efficient risk sharing procedure would use capital markets to spread the exposure to a larger number of investors. The recent emergence of “cat” bonds in advanced markets can help address the problem, but these are still not very widespread (Box II.1).11

New Instruments for Dealing with Natural Hazard Risk

A number of capital market instruments have recently become available for weather- and disaster-related risks. Most prominent among these are catastrophe bonds, or cat bonds, with other instruments including exchange-traded catastrophe options, catastrophe swaps and weather derivatives. Cat bonds offer high yields but are subject to default if a covered catastrophe occurs during the life of the bond. Securitizing catastrophe risk in this way enables the risk to be spread more widely, thereby improving the efficiency of risk transfer. While these new instruments are still in their infancy and have so far only been used in developed countries, they could help developing countries obtain large-scale protection against natural hazard risk. For example, a government could issue a cat bond to protect itself against the risk of a major hurricane. The proceeds from the bond would then be invested in risk-free securities with the spread between the two effectively representing the recurring cost of insurance. If the specified hurricane occurs, the government would default on the cat bond and would then be free to use the funds placed in risk free securities to cover its reconstruction costs. In order to minimize ambiguity, the bond should be tied to objective criteria such as wind-speed or flood height at a specified location.

22. The shortcomings of the market for natural hazard insurance are especially pronounced in developing countries, including the ECCU. This is evident in the fact that the percentage of natural disaster damage covered by insurance is much lower than in advanced economies. Poorly developed legal and financial systems (where issues related to natural hazards are concerned), as well as the large exposure to natural hazards and their frequent occurrence mean that the cost of insurance in these countries is high and volatile. As a result, insurance penetration and the quantity of risk transfer is low (Freeman et al., 2003). Latin America and the Caribbean has the lowest insurance cover of any region in the world, with only 3.9 percent of 1985–99 natural disaster damage covered by insurance, compared to 34.5 percent in North America—the region with the highest coverage (Charvériat, 2000).

23. While the ECCU insurance market is relatively advanced in comparison to that in other developing countries, coverage is not very widespread and costs are much higher than in advanced economies. Relative to the economy total property insurance premiums in the ECCU are not that much lower than in the U.S. (about 2.4 percent of GDP compared to 3.3 percent). However, this is largely a reflection of high prices, with base property insurance rates in the ECCU countries about double the rate prevailing in less hurricane-exposed cities in the U.S. (Pollner, 2001). Also, the vast majority of property insurance relates to large commercial businesses, especially in the tourism sector. In contrast, even though lenders typically require mortgage holders to be insured, a large part of private dwellings are uninsured, particularly among low-income households. Public sector use of market insurance is generally very limited, although St. Kitts and Nevis has recently moved toward insuring a majority of government assets (World Bank, 2003). In addition, crop insurance is not always available to farmers, one exception being the WINCROP scheme.12

Overall, the insurance market suffers from a high expense ratio, high fragmentation, and a low level of available risk capital.13 With a limited domestic capital base and about 80 percent of gross property insurance premiums transferred to re-insurers, the East Caribbean insurance market is highly exposed to the volatile global re-insurance market. This has caused local insurance rates to be unduly affected by natural catastrophes in industrial countries. For example, the swings in global re-insurance rates following Hurricane Andrew in Florida (1992) and the Northridge earthquake in California (1994), had a pronounced impact on property insurance rates in the Eastern Caribbean, with the annual cost of insurance jumping from 0.4 percent of insured value in 1990, to 1.3 percent in 1994, and back to 0.7 percent in 1998.

Domestic Public Policy to Reduce Risk and Lessen the Impact

24. While many countries have taken steps to improve their preparedness, increasing the efficacy of domestic policy measures could help reduce the adverse effects of natural disasters. Of particular importance in the ECCU is the need to improve the functioning of the insurance market, to increase coverage in the face of the high natural hazard risk and in order to reduce economic volatility. Here, government property could be insured more widely, possibly by using cat bonds or other financial innovations. Policies to encourage more widespread insurance of dwellings and crops would also be beneficial, particularly in low-income communities. Strengthening financial regulation would improve the insurance product, making it attractive to a wider segment of the economy.

25. In addition to promoting market-based insurance, very modest investments can often substantially reduce the structural vulnerability of infrastructure and buildings. By one estimate, investments of US$40 billion in disaster preparedness, prevention, and mitigation would have reduced global economic losses in the 1990s by US$280 billion (Freeman et al., 2003). For example, simple measures such as tying walls to foundation and roofs to walls may dramatically increase buildings’ resistance to hurricanes (Pollner, 2001). Well designed and strictly enforced building codes and zoning regulation are central to ensuring that construction methods are appropriate for the local environment. Implementing hurricane-resistant home improvement programs to encourage safer building practices in the informal sector, as done in Antigua and Barbuda, Dominica, and St. Lucia, can also have very positive results. In other areas, governments should refrain from subsidizing monoculture, as diversification within agriculture and from agriculture to other sectors would lessen the concentration of risk.

26. The high vulnerability to natural hazards in the ECCU countries cannot be eliminated, however, and it is important for governments to be prepared for the next large disaster. Further development of emergency procedures would facilitate an effective and speedy response, and help ensure that social safety nets are in place when needed without relying extensively on administrative discretion. Accumulation of contingency funds, such as those held at the Eastern Caribbean Central Bank (ECCB), would also help in this regard.14

International Assistance and Cooperation

27. External assistance plays an important role in helping countries mitigate the effects of exogenous shocks, but more is needed. An increasing share of official development assistance is being devoted to emergency assistance, and multilateral financial institutions are also doing more in this area.15 Nevertheless, the very rapid increase in the frequency of natural disasters around the world suggests a need for increasing efforts in this area. In addition, the majority of external assistance for natural disasters has been concentrated on a few very visible events, and it is possible that smaller disasters getting little media coverage are receiving too small a share of assistance (IMF, 2003).

28. The IMF has several instruments for providing financial assistance in response to natural disasters.

• The emergency assistance for natural disaster (EAND) facility aims to provide quick-disbursing assistance to member countries that cannot meet their immediate financing needs arising from a natural disaster without a serious depletion of their foreign reserves. Assistance is not subject to phasing or performance criteria (although the member is required to provide a statement of policies) and access is generally limited to 25 percent of quota. The EAND facility has been used 25 times since 1962, at an average of 31 percent of quota, including by Grenada (2003), St. Kitts and Nevis (1998), St. Lucia (1980), St. Vincent and the Grenadines (1980), and Dominica (1979).

• The compensatory financing facility (CFF), while not directly targeted at natural disasters, is another source of IMF financing that could appropriately be used. The CFF was established in the 1960s to assist countries experiencing either a temporary decline in export earnings or a temporary increase in the cost of cereal imports. Access is formula-based—determined by calculating the deviation of the shortfall or excess year from the trend over a five-year period—and limited to 45 percent of quota (55 percent for combined shocks). Stand-alone purchases are free from conditionality. The facility has been used 344 times, at an average of 36 percent of quota, with 42 purchases since 1990 of which 8 were for weather-related causes. No purchases have been made under the facility since 1999.

• Stand-By arrangements in the credit tranches are general purpose financing instruments that have been used to assist members with all types of balance of payments difficulties, including those resulting from natural disasters. While Stand-By arrangements in the credit tranches offer more flexibility than the CFF and potentially greater amounts than both the EAND and the CFF, purchases are subject to conditionality and the facility has rarely been used as a stand-alone response to natural disasters.

• PRGF arrangements are the Fund’s principal means of providing concessional financing to low-income countries. For countries with an existing PRGF arrangement, augmentation may be a practical response to an exogenous shock. As of end-August 2003, augmentation had occurred in 23 of 93 PRGF arrangements. These augmentations were mostly in response to exogenous shocks and the median size was 10 percent of quota.

29. In view of the comparatively large resource needs following disasters in small countries, IMF resources available for countries hit by natural disaster are relatively limited. The EAND facility would be the most obvious candidate for Fund financing in the event of a natural disaster. However, the funds available here often pale in comparison to the cost of shocks—the average amount of financing given in the five cases where ECCU countries have used this facility was only US$2.1 million, about 5 percent of the estimated damage. In addition, except for PRGF purchases, IMF funds are subject to the standard rate of charge on GRA resources, which is onerous for low-income countries. The main benefit of Fund assistance following a natural disaster is that it can be provided relatively quickly (for EAND usually within two or three months after the event) with relatively little conditionality (for EAND and CFF), and that it can act as a catalyst for other donor flows. Stand-By and PRGF arrangements, while allowing for larger access, are slower to disburse and subject to conditionality.

E. Summary of Findings

30. The evidence presented in this chapter shows that natural disasters have important macroeconomic implications:

  • Across countries, natural disasters on average affect about 2 percent of the population each year and cause damage of well over one-half of 1 percent of GDP. The incidence is especially pronounced in developing countries, with the ECCU countries standing out as among the most vulnerable in the world. Given the increasing frequency of events, there is a need for polices to better mitigate and respond to these occurrences.

  • Natural disasters are typically associated with an immediate contraction in economic output, a worsening of external and fiscal balances, and an increase in poverty. Although their vulnerability is mostly the result of a high frequency of events (typically hurricanes), the highly open ECCU countries also appear to suffer particularly large impacts on external balances.

  • While the long-term impact of natural disasters is hard to quantify, rank correlations suggest that proneness to natural disaster is associated with low per capita income; high volatility of income, consumption, and fiscal balances; a large agricultural sector; and a low investment ratio.

  • The proneness of developing countries to natural disasters contrasts to the limited role of insurance in these countries. Although the market is more advanced than in many other developing countries, property insurance is not very widespread in the ECCU, especially among low-income households. Overall, the ECCU insurance market suffers from a high expense ratio, high fragmentation, high volatility, and a small capital base.

  • Modest investments in preventive measures can often substantially mitigate the impact of natural hazards. Natural disasters cannot be eliminated, however, and it is important for governments to be prepared. In ECCU countries, a tighter fiscal policy during good times would leave more room for expenditure increases in emergencies, reducing the risk that a natural disaster leads to an economic crisis. Accumulation of contingency funds would bring important benefits in this regard.

  • International assistance has played an important role in helping countries faced with natural disasters. More can be done, however, not least by the IMF, where resources available for countries hit by natural disasters are relatively limited.

References

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1

Prepared by Tobias Rasmussen.

2

The main source of data on natural disasters used in this paper is the EM-DAT database compiled by the Centre for Research on the Epidemiology of Disasters (CRED, 2003). Natural disasters are here defined as events due to natural causes that caused 10 or more fatalities, affected 100 or more people, or resulted in a call for international assistance or the declaration of a state of emergency. This database contains information on 8,815 natural disasters from 1900–2002, including estimates of the number of people affected and the value of damage. The total number of affected is defined as people that have been injured, made homeless, or requiring immediate assistance during a period of emergency. Estimates of the number affected are available in only about two thirds of cases and are subject to significant uncertainty. The figures for estimated damage are available in only about one third of cases and are even more questionable, with CRED figures coming from a number of different sources using different methodologies. The data should therefore be interpreted with caution. Note also that windstorms and other natural events may have substantial implications even if they do not meet the EM-DAT definition of a natural disaster. In the ECCU, for example, even relatively minor tropical storms have often had large impacts on agricultural output. Despite the wealth of information, the EM-DAT data still suffers from under-reporting, especially in the earlier periods, and the analysis consequently focuses on the period since 1970.

3

The regressions suffer from hetereoscedasticity, but the results are generally robust to corrections for this using different statistical methods.

4

Crowards and Coulter (1998), ECLAC (2000), and Pollner (2001) reach a similar conclusion. At a broader level, the findings are also in line with the composite vulnerability indexes proposed by several international institutions (see Atkins et al., 2000; Crowards, 2000a; and United Nations, 2000). In addition to proneness to natural disaster, these indexes include factors such susceptibility to terms of trade shocks and concentration of exports to rank countries according to their overall vulnerability. The different indices all find that small, isolated, and low-income countries are the most vulnerable, with the ECCU countries in most cases ranking among the very most vulnerable.

5

Interestingly, the results do not reveal clear differences between the ECCU countries. Given that the northern islands (St. Kitts and Nevis, Antigua and Barbuda, and Dominica) are closer to the center of the hurricane belt than the southern islands (St. Lucia, St. Vincent and the Grenadines, and Grenada), one would have expected the former countries to rank higher in terms of vulnerability to natural disaster, but that is not consistently the case.

6

The events under consideration are the 12 natural disasters with estimated damages exceeding 2 percent of GDP shown in Table II.3 (the 1987 hurricane and flood in St. Vincent and the Grenadines are treated here as a single event).

7

Crowards (2000b) finds a median 13 percentage point reduction in the growth rate of tourist arrivals following natural disasters in the Caribbean.

8

IMF (2003), citing a number of different studies, finds that exogenous shocks and the associated policy responses have contributed to the accumulation of unsustainable external debt in many developing countries, but also that a strong policy response by governments can help prevent a lasting impact on the debt burden.

9

This result refers to the standard deviation of annual real GDP growth. Interestingly, as documented in Chapter I of this paper, filtering out the effect of business cycles dramatically increases the volatility of real GDP growth in the ECCU relative to that of other countries.

10

The relatively limited role of insurance in the Caribbean may indirectly be a result of the proneness to natural hazards, which may impede the efficiency of the insurance market.

11

See Pollner (2001) for an overview of new financial instruments for managing weather and disaster risks.

12

The Windward Islands Crop Insurance, or WINCROP, provides storm insurance for banana growers. The scheme, which covers the entire export crop in Dominica, Grenada, St. Lucia and St. Vincent and the Grenadines, only provides cover against a small proportion (20 percent) of losses, but this has proven sufficient to enable growers to rehabilitate quickly.

13

As documented by Pollner (2001), expense ratios of local insurance companies are between 30–40 percent of premium income, compared to the U.S. average of 26–28 percent.

14

The ECCB has a fiscal reserve account to assist member countries facing economic difficulties, including those caused by natural disasters. Contributions to the account are mandatory, with an amount automatically deducted from the profits owed to each member country, and the terms of drawings are determined on a case-by-case basis. The account, which has been in place for a decade, currently holds about EC$12 million and has only been used once (not in relation to a natural disaster).

15

See IMF (2003) for an overview of international financing mechanisms for addressing exogenous shocks. Of particular relevance for the ECCU are the programs sponsored by the Caribbean Development Bank (CDB), the Caribbean Disaster Emergency Response Agency (CDERA), and the World Bank. The CDB provides assistance for disaster relief, mitigation, and preparedness projects, and disbursed US$50 million in loans for 27 operations during 1998–2001. CDERA is a regional agency established by CARICOM in 1991 to provide immediate and coordinated response to disastrous events in member countries. Whilst the Agency’s mandate originally focused on disaster response, it is now engaged in a wide array of services, ranging from local information campaigns to logistical support for dispatch of relief supplies. The World Bank has a number of ongoing projects in the region relating to disaster management and emergency recovery.

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Cover IMF Staff Country Reports
Eastern Caribbean Currency Union: Selected Issues
Author:
International Monetary Fund
Volume/Issue:
Volume 2004: Issue 335
Publisher:
International Monetary Fund
ISBN:
9781451811667
ISSN:
1934-7685
Pages:
160
DOI:
https://doi.org/10.5089/9781451811667.002
  • Figure II.1.
    View in gallery
    Figure II.1.

    Global Frequency and Impact of Natural Disasters. 1970-2002

  • Figure II.2.
    View in gallery
    Figure II.2.

    Cross-Country Frequency and Impact of Natural Disasters, 1970-2002

  • Figure II.3.
    View in gallery
    Figure II.3.

    Median Impact of 12 Large Natural Disasters in the ECCU, 1970-02

Figure II.1.

Global Frequency and Impact of Natural Disasters. 1970-2002
Figure II.2.

Cross-Country Frequency and Impact of Natural Disasters, 1970-2002
Figure II.3.

Median Impact of 12 Large Natural Disasters in the ECCU, 1970-02