Seychelles: Selected Issues
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International Monetary Fund. African Dept.
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Selected Issues

Abstract

Selected Issues

Long-Term Implication of Climate Change on Public Debt Dynamics1

Seychelles could be vulnerable to severe natural disasters caused by climate change. While the authorities announced their long-term action plan on climate change mitigation and adaptation, it entails significant fiscal cost. Meanwhile, a natural disaster triggered by an extreme weather event could put the public debt dynamics on an unsustainable path. In this context, the authorities are encouraged to articulate long-term fiscal plans to accommodate the mitigation and adaptation investments and seek to reduce vulnerability to catastrophe.

A. Background

1. While catastrophic natural disasters have so far spared Seychelles, the country would be potentially vulnerable to natural disaster caused by climate change. In its recent history, it was hit only once by a major natural disaster which entailed economic damage over 2 percent of GDP—the average annual cost of natural disasters for small states.2 Based on the history, Seychelles ranks 26th among 33 small states worldwide as to the vulnerability to natural disasters and climate change.3 However, as a small archipelagic country, it faces unique challenges regarding natural disasters in the context of climate change. In the long run, rising sea level could pose a serious threat. In the meantime, it may face a catastrophic weather event at any time albeit with low probability.

Seychelles: Major Natural Disasters

article image
Source: EM-DAT

2. The authorities announced their long-term action plans to address the vulnerability to climate change in September 2015. The country is committed to a multilateral agreement under the United Nations Framework Convention on Climate Change (UNFCCC), which will come into effect in 2020. The authorities estimate that the total cost of priority mitigation and adaptation actions would stand at US$604 million (US$309 million for mitigation and US$295 million for adaptation): 43 percent of the estimated 2016 GDP.4 This chapter estimates how climate change mitigation and adaptation investments would affect the long-term public debt dynamics under the baseline scenario envisaged by the Extended Arrangement (EFF baseline scenario), illustrates how a catastrophic natural event could severely derail the country’s hard-won economic stability centered on the public debt reduction since the crisis in 2008, and draw some policy implications.

B. Impact of Climate Change on Long-Term Public Debt Dynamics

3. Under the EFF baseline scenario, the public debt to GDP ratio is expected to decline steadily over medium to long term. At the time of the fourth and fifth review under the EFF, the authorities committed to a primary surplus of 3 percent of GDP from 2017 onwards. Assuming the GDP growth would stay around the estimated potential rate (3–3½ percent) after 2018, such policy would allow the public debt to GDP ratio to fall below 50 percent by 2020: the medium-term policy anchor under the EFF. After 2020, we assume that the authorities would stick to prudent policies and the external environment would continue to be benign as follows:

The primary surplus would remain at 3 percent of GDP until 2022, then gradually decline each year to balance after 2030; GDP growth would stay around 3–3½ percent after 2020; and CPI inflation would stay at 3 percent. Under this baseline assumption, the public debt ratio would continue to decline gradually over the long term and would fall to 16½ percent by 2036 (see Figure below).

4. The authorities’ ambitious action plan on climate change mitigation and adaptation would slow down the public debt reduction path significantly. We make following changes to the EFF baseline scenario: Mitigation and adaptation investments would be executed evenly over the period of 20 years starting in 2018 (primary balance would worsen by the amount of these investments, whose financing is yet to be identified, each year compared with the baseline5); One- third of the mitigation and adaptation investments would be financed by external project grants, another one-third by concessional external project loans, and the rest by domestic sources;6 and GDP growth would notch up starting in 2025 and reach 4½ percent by 2036, thanks to more efficient, clean energy infrastructure, other augmented infrastructure such as roads and ports, and stronger growth in tourism and fishing related industries buoyed by resilience to natural disasters.

uA02fig01

Seychelles: Public Debt

(In Percent of GDP)

Citation: IMF Staff Country Reports 2017, 161; 10.5089/9781484304792.002.A002

Source: IMF Staff projections.

5. Although the public debt is projected to decline each year even under this scenario, it falls below 50 percent by 2022, two years later compared with the EFF baseline (see Figure below). The public debt to GDP ratio at the end of the projection period under this scenario is estimated at around 26 percent, a reasonably low level but still significantly higher compared with the EFF baseline. When we assume all the climate change related investments are financed domestically, the debt to GDP ratio would decline at a much slower pace than under the EFF baseline and is projected to stand at around 36½ percent in 2036. This highlights the importance of finding concessional external sources to finance the investments.

6. A catastrophic natural disaster could severely derail the country’s hard-won economic stability centered on the public debt reduction since the crisis. Although Seychelles has so far not experienced such a disaster, a mega storm could hit the country at any time given the climate change. We assume, as a tail risk scenario, that the country would be hit by a catastrophic storm causing economic damage of 30 percent of GDP in 2017, before the country starts implementing mitigation and adaptation investments.7 We make the following assumptions under this catastrophic disaster scenario:

GDP would be reduced by 30 percent in 2017 in real terms compared with the baseline, real GDP growth rate would be the same as the baseline rate during 2018–19,8 it would accelerate to around 8½ percent during 2020–22 buoyed by a rebound in tourism and fishing related industries and reconstruction activities, and then it would return to the same rate as the EFF baseline with climate change investments after 2023;The Seychelles rupee would depreciate by 30 percent against the major currencies in 2017, and gradually recover to the same level as the baseline by end-2022; CPI inflation would accelerate to over 15 percent by end-2017 and gradually decline to the baseline rate by 2020. Reconstruction investments, total costs of 15 percent of GDP, would be implemented over the five-year period starting 2018 (3 percent of GDP per year); One-third of the reconstruction costs would be financed by external project grants, another one-third by concessional external project loans, and the rest by domestic sources; Climate change mitigation and adaptation investments would be implemented as in the climate change investment scenario.

uA02fig02

Seychelles: Public Debt

(In Percent of GDP)

Citation: IMF Staff Country Reports 2017, 161; 10.5089/9781484304792.002.A002

Source: IMF Staff projections.

Under this catastrophe scenario, the public debt to GDP ratio would spike to 115 percent in 2017 from slightly over 70 percent in 2016, due to a massive revenue decline and valuation impact of external debt. Public debt to GDP ratio would gradually decline for the next several years to around 90 percent supported by economic growth and revenue recovery and external grants and concessional lending. However, it is projected to rise again in mid-2020s as the principal repayments to the concessional borrowing resumes, coupled with much heavier interest payment burden and climate change mitigation and adaptation actions: it could reach 120 percent by 2036 (see Figure below). One natural catastrophe could completely undo the Seychelles’ hard-won economic stability in the past eight years.

7. A natural disaster of a much smaller scale than the previous scenario could prevent the public debt from declining steadily. The figure below illustrates the long-term dynamics of public debt when Seychelles is hit by a storm causing economic damage of 10 percent of GDP in 2017. We apply the similar assumptions on the path of GDP growth, exchange rates, inflation, reconstruction investments and their financing to the previous scenario on a smaller scale:

  • GDP would be reduced by 10 percent in 2017 in real terms compared with the baseline, real GDP growth rate would be the same as the baseline rate during 2018–19, it would accelerate to around 6 percent during 2020–22, and then it would return to the same rate as the EFF baseline with climate change investments after 2023;

  • The Seychelles rupee would depreciate by 15 percent against the major currencies in 2017, and gradually recover to the same level as the baseline by end-2022;

  • CPI inflation would accelerate to over 10 percent by end-2017 and gradually decline to the baseline rate by 2020.

  • Reconstruction investments, total costs of 5 percent of GDP, would be implemented over the five-year period starting 2018 (1 percent of GDP per year) and financed in a similar way to the previous scenario;

8. Under this scenario, the public debt to GDP ratio would spike to around 85 percent in 2017 from slightly over 70 percent in 2016. While it would gradually decline for the next several years to slightly below 50 percent supported by economic growth and revenue recovery and external grants and concessional lending, it is projected to stop declining after that as the principal repayments to the concessional borrowing resumes. The public debt to GDP ratio could reach 51 percent by 2036.

C. Policy Implications

9. Going forward, Seychelles is encouraged to step up efforts to enhance ex-ante resilience and ex-post adaptive capacity. Although Seychelles has not encountered severe natural disasters so far and the probability of such an event takes place would be quite low, the catastrophe scenario illustrated above implies that the fiscal sustainability could be easily jeopardized by one severe natural disaster. Furthermore, even without such an event, over the long-term Seychelles would be exposed to a threat posed by rising sea level in the context of global warming without adequate mitigation and adaptation investments.

uA02fig03

Seychelles: Public Debt

(In Percent of GDP)

Citation: IMF Staff Country Reports 2017, 161; 10.5089/9781484304792.002.A002

Source: IMF Staff projections.

10. Although natural disasters and climate change are beyond Seychelles’ control, cross-country best practice and the authorities’ Nationally Determined Contribution (NDC) under the UNFCCC suggest several important elements of an effective strategy:

Create fiscal space for climate change mitigation and adaptation over the medium term. Climate change related spending is estimated to cost almost 1 percent of GDP each year over the next 15–20 years. The authorities should articulate measures to enhance revenue and control expenditure to create space for this critical public investment. On the revenue side, the authorities could (i) introduce a carbon tax gradually in line with the recent FAD recommendation; (ii) introduce the sugar tax that is under consideration; and (iii) align the business tax of the tourism and fishing sectors with the other sectors. On the expenditure side, (i) growth in wage bill and goods and services could be contained to a level significantly lower than the trend recent years; (ii) SOE sector reform could save current transfers to SOEs over the medium term; (iii) the social welfare program could be better targeted; and (iv) full implementation of Program Performance Based Budgeting (PPBB) and effective use of Public Private Partnership (PPP) could improve efficiency of public investment and create space for climate change related investments.9.

Incorporate disaster risks in public finance management. The government needs to explicitly integrate climate-related natural disaster risks into the medium-term fiscal framework and debt sustainability analysis. This would help identify how much to self-insure by creating an adequate fiscal buffer within the budget. Capacity building support from the Fund and other IFIs could play an important role on this front.

Explore disaster risk transfer mechanism.10 This issues is discussed in detail in the next chapter.

1.

Prepared by Tetsuya Konuki (AFR).

2.

See the Board paper “Small States’ Resilience to Natural Disasters and Climate Change—Role for the IMF” (IMF, November 2016).

3.

See Annex I, “Small States’ Resilience to Natural Disasters and Climate Change—Role for the IMF” (IMF, November 2016).

4.

Republic of Seychelles, “Intended Nationally Determined Contribution (INDC) Under the United Nations Framework Convention on Climate Change (UNFCCC)” (September 2015)

5.

Out of the climate mitigation and adaptation projects which would cost $604 million, projects amounting of about $25 million are listed in the authorities’ Public Sector Investment Plan (PSIP).

6.

Mitigation and adaptation investments would reduce the primary surplus by ¼–1¼ percent of GDP each year during the projection period compared with the EFF baseline scenario.

7.

About 9 percent of disasters in small states involve damage of more than 30 percent of GDP (see the Board paper “Small States’ Resilience to Natural Disasters and Climate Change—Role for the IMF” (IMF, November 2016)).

8.

Tourism and fishing industries activities would continue to be subdued for two years after the disaster, which will offset the positive impact of reconstruction activities.

9.

See another SIP chapter “Possible Options to Buttress the Authorities’ Medium-term Debt Target”.

10.

See another SIP chapter “Climate Change and Disaster Risk Management”.

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Seychelles: Selected Issues
Author:
International Monetary Fund. African Dept.