Small States Resilience to Natural Disasters and Climate Change - Role for the IMF

Small developing states are disproportionately vulnerable to natural disasters. On average, the annual cost of disasters for small states is nearly 2 percent of GDP—more than four times that for larger countries. This reflects a higher frequency of disasters, adjusted for land area, as well as greater vulnerability to severe disasters. About 9 percent of disasters in small states involve damage of more than 30 percent of GDP, compared to less than 1 percent for larger states. Greater exposure to disasters has important macroeconomic effects on small states, resulting in lower investment, lower GDP per capita, higher poverty, and a more volatile revenue base.

Abstract

Small developing states are disproportionately vulnerable to natural disasters. On average, the annual cost of disasters for small states is nearly 2 percent of GDP—more than four times that for larger countries. This reflects a higher frequency of disasters, adjusted for land area, as well as greater vulnerability to severe disasters. About 9 percent of disasters in small states involve damage of more than 30 percent of GDP, compared to less than 1 percent for larger states. Greater exposure to disasters has important macroeconomic effects on small states, resulting in lower investment, lower GDP per capita, higher poverty, and a more volatile revenue base.

Introduction

1. This paper explores the burden on small developing states as a result of natural disasters and climate change.1 Many small island states are highly vulnerable to storm damage and some face a perilous future as a result of sea level rise. To minimize the human and economic cost of disasters and climate change, a more proactive policy approach is needed, with a shift by both domestic policymakers and the global community toward advance planning rather than “after the event” disaster response. Small states should integrate risk reduction and disaster response programs into their core budget and debt management frameworks. To smooth the impact of shocks, they need access to external financing and risk transfer options. The paper builds on a range of earlier Fund work on the risks from climate change and natural disasters, including small states country reports and the cross-country analysis cited in Box 1.

Definition and Vulnerabilities of Small States

The IMF membership includes 34 small developing states, comprising countries with a population below 1.5 million that are not advanced market economies (according to the World Economic Outlook’s classification) or high-income oil exporting countries (following the World Bank’s categorization).2 About half of the group are lower or lower-middle income states. The vast majority of small states are defined as small island developing states (SIDS) by the UN, a group comprising 52 low-lying coastal countries sharing similar challenges to sustainable development, and many are members of the Alliance of Small Island States.3

“Smallness” reduces scope for economies of scale in production, distribution, and public administration, undermining competitiveness, hampering the delivery of public goods, and hindering diversification against external shocks. Where small states have not adopted strong and sustained policy responses, including structural reforms, these factors have contributed to weak growth, macroeconomic volatility, and, for some, higher debt levels since the 2000s. The challenges associated with diseconomies of scale were discussed in recent Board papers (IMF, 2013a, 2013b, 2013c, 2014b, and 2015c).

2. Coverage of this paper. The opening two sections review the impact on small developing states of natural disasters and climate change. These sections discuss the outlook for and impact of disasters and climate change, and the key transmission channels within the economy. The third section of the paper looks at how public policies can help build resilience to natural disasters and climate change. It looks at key elements of a holistic disaster management framework, and explores the implications for fiscal, financial, and external policies. This section emphasizes, in particular, the role of the Fund in advising on policy frameworks. A fourth section examines approaches for financing natural disasters and climate change, outlining an optimal approach and explaining what factors lead practice to fall short. This section concludes with a detailed discussion of the different elements of the financing “toolkit” and explores how access to finance could be further strengthened. The paper concludes with a discussion of the particular role played by the Fund in financing natural disasters and supporting countries as they seek to access climate change financing.

3. Fund engagement. With progressive climate change, the economic challenges faced by small states are likely to rise, including as a result of more frequent and more damaging natural disasters. Given this, it will be important that the Fund respond to members’ needs using all available instruments—economic analysis and policy advice, Fund financing, and capacity building. Moreover, policies for managing natural disasters and climate change should be integrated into the Fund’s tool kit on a sustained basis, applied routinely, and updated as new policy challenges emerge. In these areas, the Fund also has an important role to play in facilitating the sharing of cross-country experience.

4. Collaboration with other institutions will remain critical. Where preparedness for natural disasters and climate change requires expertise on policies and institutional frameworks outside the competence of Fund staff, close collaboration with other institutions, such as the World Bank, will be needed.

Impact of Natural Disasters

The cost of natural disasters for small developing states is more than four times that for larger countries, relative to the size of their economies. A key factor is the larger tail-risk of extremely damaging disasters for small states. Greater vulnerability to disasters is associated with lower investment, lower GDP per capita, higher poverty, and a more volatile revenue base.4

A. Impact and Frequency of Natural Disasters in Small States

5. Small states are proportionately more vulnerable to natural disasters. According to the most widely used database on natural disasters (EM-DAT, Box 2), the economic cost of the average natural disaster during 1950–2014 was equivalent to nearly 13 percent of GDP for small states compared to less than 1 percent of GDP for larger states (Table 1).5 Similarly, the average natural disaster affects 10 percent of the population in small states, compared to 1 percent for other countries.6

Table 1.

Average Effects of Disasters by Region and Income, 1950–2014

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Sources: EM-DAT; WEO; WDI; and IMF staff calculations.

In 2010 c onstant US dollars.

6. The greater vulnerability of small states applies to almost all categories of natural disaster. Across a wide range of disasters (except extreme temperatures), an occurrence in a small state is proportionately more damaging than an equivalent event in a larger state, making the recovery in the aftermath of a disaster more challenging. For example, a disaster-level storm is 23 times more damaging than for large states, measured as a share of GDP (Table 2). This partly reflects the large number of small developing states that are islands, so that when a storm makes landfall it affects a larger proportion of the population. Greater damage may also reflect the more constrained fiscal space of small states which can preclude adequate advance investments in risk reduction.

Table 2.

Average Effects of Disasters by Type, 1950–2014

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Sources: EM-DAT; WEO; WDI; and IMF staff calculations.

In 2010 constant US dollars.

Data on Natural Disasters

Coverage. The analysis in this section draws on the EM-DAT database, the most comprehensive global source on natural disasters and most widely used in the literature. The database covers 13,000 natural disasters for the period 1950–2014, with information on the date, location, and type of disaster, and their human and economic cost. It covers disasters that meet at least one of the following criteria: (i) 10 or more people reported killed; (ii) 100 or more people reported affected; (iii) a declaration of a state of emergency, or (iv) a call for international assistance.1/ More detailed evaluations on the impact of selected disasters are also available through UNDP Post-Disaster Needs Assessments (PDNAs).

Limitations. A key challenge is how to measure the impact of natural disasters, which not only damage property but also lead to the loss of current and future incomes (some key concepts are outlined in the table below). The EM-DAT database, in principle, covers both property damage and income losses, but does not differentiate between the two. Moreover, while EM-DAT reports the human impact for about 90 percent of disasters, economic damage is reported for only 32 percent of disasters (36 percent for small states). Estimates for economic damage are more readily available for some types of disasters, such as storms, but rarely for epidemics.2/ Also, in general, richer countries tend to have a better records of economic damages than low income countries, while the latter tend to have a better reporting of people affected or killed. Separate estimates of property damage and income losses are available through PDNAs, but for only a limited number of disasters.

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1/ EM-DAT is maintained by the Centre for Research on the Epidemiology of Disasters at the School of Public Health of the Université Catholique de Louvain, Belgium (see Guha-Sapir et al., 2015). Other data on natural disasters are available from the NATCAT service by Munich Re and through the World Bank’s Pacific Risk Assessment and Financing Initiative (PCRAFI) and Caribbean Catastrophe Risk Insurance Facility (CCRIF).2/ The classification of natural disasters includes: geophysical (earthquake, mass movement, volcanic activity), metrological (extreme temperature, fog, and storms), hydrological (flood, landslide, wave action), climatological (drought, wildfire) and biological (epidemic, insect infestation).

7. Disasters not only cost more in small states, but are also more frequent (adjusting for land area) (Table 3).7 Ranked by frequency of disasters in relation to land area, 21 of 33 small states are in the global top-50. Small states, as a consolidated group, experienced 460 disasters between 1950–2014, an average of 7 disasters within the group each year. By contrast, eight countries with roughly similar overall land area to the combined small states experienced only 66 disasters over the same period, or roughly one each year.8 The higher frequency of disasters partly reflects the unfavorable location of many small island states in the cyclone and hurricane belts each side of the equator.

Table 3.

Average Annual Effects of Disasters

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Sources: EM-DAT; WEO; WDI; IMF staff calculations.

In 2010 constant US dollars.

Average annual disasters per 1,000km2.

8. Reflecting frequency and impact, the cost of disasters over time is higher for small states. Over the last 25 years, the annual damage (including both disaster and non-disaster years) averaged 1.8 percent of GDP for small states compared to 0.4 percent of GDP for other countries (Table 3).9 The cost estimate for small states may also be an underestimate. Adjusting for under-reporting, Acevedo (2016) suggest that damages for the Caribbean could be 1.6 to 3.6 times larger than reported in the EM-DAT database.

9. Large disasters are a “fatter tail risk” for small states. Given their much smaller economic base, disasters resulting in damages equivalent to large shares of GDP are much more common in small states. EM-DAT data suggest that about 9 percent of disasters impacting small states create damages equivalent to 30 percent or more of GDP, compared to less than 1 percent for larger states (Figure 1).

Figure 1.
Figure 1.

Disaster Distribution for Small and Larger States

Citation: Policy Papers 2016, 038; 10.5089/9781498345095.007.A001

Sources: EM-DAT; WEO: WDL and IMF staff calculations.

10. The 2000s saw a record number of global disasters, as well as rising intensity. Data show an increasing trend in the frequency of disasters (both globally and for small states) that partly reflects better reporting (Figure 2). EM-DAT started to systematically record disasters only in 1988; prior to that date, information was collected from historical sources such as newspapers and official reports. The earlier information may be less accurate and comprehensive, particularly for small- and medium-scale disasters.10 Since the late-2000s, the frequency of disasters has declined throughout regions, income levels and disaster types, likely due to cyclical climatic factors. The trend in disaster frequency does not take into account the intensity of disasters, which is continuing to rise.11

Figure 2.
Figure 2.

Small States: Number of Natural Disasters per Year

Citation: Policy Papers 2016, 038; 10.5089/9781498345095.007.A001

Sources: EM-DAT; and IMF staff calculations.

11. Relative vulnerability across small states to natural disasters is summarized in Annex 1. Over one-third of small states (13 countries) are assessed by staff to be at extreme risk of natural disasters, comprising five Pacific countries (Kiribati, Palau, Samoa, Tonga, Vanuatu), six Caribbean countries (Antigua and Barbuda, Belize, Dominica, Grenada, St. Lucia, St. Vincent and the Grenadines) and two other small states (Comoros and Maldives).

B. Transmission Channels

12. This section discusses the macroeconomic impact of natural disasters. These represent an extreme form of a supply shock and can have macroeconomic effects that are both large and long-lasting. The literature describes the cycle of loss and recovery as a three-stage process. The first stage involves direct losses from the destruction of infrastructure and property. In the second stage, indirect losses accumulate from foregone output and incomes, and costs are incurred as individuals and business work around disruptions. Finally, as the recovery starts, rebuilding of infrastructures and replacement of damaged goods leads to a temporary boost in activity and employment in the affected area (although there may be a leakage if outside contractors are brought in). It also opens up the opportunity to upgrade infrastructures. Apart from the cycle of impact and recovery from individual disasters, the periodic destruction of part of a country’s productive assets is an implicit tax on capital which tends to deter investments and lower productivity and living standards on a sustained basis.

13. Natural disasters vary in impact depending on their type as well as with the population and economic characteristics of the affected country. For earthquakes, there is large up-front damage at the time of the shock, and also heavy rebuilding costs. Persistent droughts, by contrast, can be associated with more drawn-out damages and costs. The same type of disaster can have different impacts in different countries. The 2010 earthquake in Chile was stronger and hit a more densely populated area than the same year’s earthquake in Haiti. But because of lower construction standards, the human and economic cost in Haiti was far higher, with 200,000 people killed (1,000 in Chile) and destruction equivalent to 120 percent of GDP (14 percent of GDP in Chile) (see Cavallo and Noy (2010)).

14. There is a substantial literature documenting the macroeconomic impact of natural disasters. The findings are mixed in some cases, likely reflecting differences in country characteristics as noted above. Accordingly, assessments regarding country disaster vulnerabilities need to blend insights from the literature with specific information on country risks. The findings below are broadly supported by new Fund analysis exploring how macroeconomic outcomes are related to exposure to natural disaster risks (Annex II).

  • Natural disasters have a clear temporary impact on growth. A number of studies point to negative short-term growth effects as damage to physical assets and to commercial and financial infrastructures result in foregone production in the immediate aftermath of the disaster (Raddatz, 2007; Noy, 2009; Acevedo, 2014; Cabezon et al. 2015). Looking at a slightly longer period, reconstruction spending can lead to a positive growth impact for small disasters (Loayza et al, 2009). Hochrainer (2009) finds a significant negative medium-term impact on growth only for large shocks. Event studies confirm that hurricanes result in an initial jump in unemployment in the short term, followed by reversal to the baseline (Ewing and Kruse, 2002).

  • Evidence on the impact of natural disasters on underlying long-run growth is more mixed. Cavallo and Noy (2010) finds no significant long-run impact, while Cabezon et al. (2015) find that for the Pacific islands, trend growth over 1980–2014 was 0.7 percentage point lower than it would have been without natural disasters.

  • Fiscal balances tend to be adversely affected. The adverse impact on short-run activity tends to weaken the tax base: thus, Cabezon et al. (2015) find higher tax revenue volatility in disaster-prone Pacific small states. Spending also tends to rise on account of relief and recovery programs. Fiscal imbalances can lead to higher borrowing. Acevedo (2014) finds that floods in the Caribbean result in higher public debt burdens, while Lee et al. (2016) find that natural disasters increase public indebtedness for Pacific islands. In other cases, fiscal needs are met through grants. In some cases, the 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.

  • Natural disasters also tend to worsen the external trade balance. Damage to production and transportation capacity tends to reduce exports. Over the short term, imports could decline with the dislocation to economic activity, but would tend to rise thereafter, buoyed by disaster relief and recovery programs (Rasmussen, 2004, Cabezon et al., 2015). The deterioration tends to be larger for agricultural exporters. Other elements of the balance of payments may improve. Bluedorn (2005) finds that hurricanes lead to an increase in international aid and remittances in the short-term. Also, where countries have insured or reinsured abroad, disasters can result in balance of payments inflows as insurance companies make payments for damages (Laframboise and Loko, 2012).

  • Natural disasters can have a disproportionate impact on the poor. Low income communities tend to be located in the most vulnerable areas with weak housing standards (World Bank, 2003, 2016a, 2016b) and disasters can exacerbate social conditions. Low-income communities also commonly do not have access to credit or insurance to help weather shocks (IMF, 2003). There is also a gender element, with natural disasters having their largest impact on life expectancy for women and girls (Neumayer and Plumper, 2007).

15. Differences in the cost of natural disasters have been attributed to institutions as well as initial economic and financial conditions. Noy (2009) asserts that institutions affect the direct efficiency of the public intervention following disasters or the indirect impact by shaping the private sector response. He finds that higher literacy rates, higher degree of openness to trade, and higher levels of government spending increase the ability of governments to mobilize resources for reconstruction, mitigate the impact of the shock, and contain the spillovers on the macro economy. Economic diversification and fiscal space to conduct counter-cyclical policy can also impact the response and overall economic cost. Regarding financial conditions, countries with better reserve buffers and access to domestic credit, but with less open capital accounts, are better able to cope with disasters.

Climate Change

Climate change is expected to exacerbate the impact of natural disasters and worsen other vulnerabilities of small states. About one-third of small states are highly or extremely vulnerable to climate change in the lifespan of the current generation. Key risks are from sea level rise and declining agricultural productivity, with expected spillovers for tourism. Stressed ecosystems could boost poverty and further encourage emigration.12

16. Climate change is likely to increase disaster vulnerabilities globally and particularly for small states. Acevedo (2016) finds that climate changes increases the probability of large natural disasters (tropical storms) and raises mean damages. Specifically, by 2100, tropical storms making landfall could inflict damages up to 77 percent higher than today (with an impact up to 42 percent higher even when storms do not make landfall).13

17. Climate change is also expected to impose broader persistent costs on economies. Depending on climate change outcomes (Box 3), several transmission channels are particularly relevant:

  • Sea-level rise (SLR). SLR is projected to be directly related to the degree of global warming and proximity to the equator. SLR of 50cm by the 2050s is expected based on existing carbon emissions. This could reach 70cm with 2°C global warming (the central goal of the Paris Agreement) and over 1m with 4°C global warming. SLR close to the tropics could be 10–15 percent higher (World Bank, 2013). SLR raises the risk of storm surges, tropical cyclones, and tsunamis, as well as persistent flooding and coastal erosion. The Maldives is at risk of disappearing entirely with SLR of 1m, while other small states also face significant risks (Dominica, Grenada, Kiribati, the Marshall Islands, St. Vincent and the Grenadines, and Tuvalu).14

  • Extreme temperatures. Global warming is projected to result in more frequent and more intense episodes of extreme heat. While the marginal impact is projected to be smaller for countries closer to the equator, this comes on top of already high average temperatures for small states in the Caribbean, Pacific, and Africa.15

  • Water stress. SLR can lead to salt water contamination of freshwater aquifers, reducing access to water for drinking and crop irrigation.16 Use of alternative, less healthy water brings risk of water-borne disease. With more volatility in rainfall as a result of climate change, droughts also pose risks to water supplies.17

Climate Change Basics

Definition and drivers. Climate change refers here to the gradual change or variability in global mean temperature and related developments such as increased frequency of extreme weather events, variability in precipitation, and rising sea levels (up to several meters if ice sheets melt). There is a broad scientific consensus that manmade emissions of greenhouse gases (GHG) are a key driver of ongoing climate change and their continued trend will cause further warming and long-lasting damage to the climate system (IPCC, 2014).

Warming impact. Global mean temperature has increased progressively since 1900, and is now about 0.8°C higher, mostly from rising GHG concentrations. If carbon dioxide (CO2) equivalent concentrations were stabilized at 450, 550, and 650 parts per million (ppm), mean projected warming over pre-industrial levels would be 2, 3, and 4°C, respectively. Absent mitigation and adaptation, indications are that the global mean temperature increase could reach about 3–4°C or more by the end of this century—producing severe and irreversible change in climate conditions in many parts of the world. The central goal of the Paris Agreement is to limit global warming to 2°C.

18. Small developing states are estimated to be at greater risk than developed countries.18 Projections of climate parameters by IPCC and Maplecroft’s 2016 climate change vulnerability index suggest that countries closer to the equator and low-lying coastal countries (including many small states) are extremely or highly vulnerable to climate change. Roughly three-quarters of low-income countries and one-third of small developing states are assessed as extremely or highly vulnerable to climate change, compared to one-quarter of the rest of the world. The 2016 Maplecroft exposure index assesses risks for 24 small states, of which three are at extreme risk (Fiji, Mauritius, and Montenegro) and a further four at high risk (Belize, Djibouti, Timor Leste, and Vanuatu). This likely understates risks to small states, as a number of vulnerable states are not covered by the assessment (e.g., the low-lying Kiribati and Tuvalu, and tourism-based Maldives) (Annex I).

19. The economic impact on small developing states will be seen in several sectors. Roson and van der Mensbrugghe (2012) identify the main channels of impact as sea-level rise and agriculture for Southeast Asia, Latin America and the Caribbean; water scarcity for MENA; and labor productivity and health for sub-Saharan Africa. Key sectors at risk are the following:

  • Coastal ecosystems. Damage to coastal areas and infrastructure from SLR will have a broader impact on livelihoods (e.g., fishing) and habitability in these areas. Over the long term, climate change will make some ecosystems completely uninhabitable.19

  • Tourism. Climate change can undermine tourist-based economies through erosion of beaches, reduced freshwater supplies, and extreme climate events (floods, storms, and tsunami) which damage critical infrastructure (airports, roads and hotels). The loss of tourism competitiveness will likely reflect overall stress from climate change, being greatest for developing countries, particularly small developing states vulnerable to SLR.20 This is a major source of risk for the most tourism-dependent small states.21

  • Agricultural productivity. A number of studies have found that the combination of rising temperatures and greater rainfall volatility (including periods of drought), reduce agricultural productivity and GDP growth (e.g., Reilly and Schimmelpfennig, 1999). With 97 percent of crop land being rain-fed rather than irrigated, countries in sub-Saharan Africa and Southeast Asia are particularly vulnerable (World Bank, 2013). One study projects that output in poor countries could fall by 1.3 percent on average from baseline levels for each 1°C rise in global mean temperatures, largely due to reduced agricultural and industrial output (Dell et al., 2012). Lower crop yields from unfavorable growing conditions are also projected to boost food prices, with implications for low-income groups (Hallegatte et al., 2015).

20. The economic costs of climate change for small states are projected at 15 percent of GDP or more. For Caribbean small states, a one-meter sea-level rise by 2080 is projected to result in losses and damages of about 8 percent of projected GDP (Simpson et al., 2010). For Pacific island small states, a sea level rise of between 1 and 1.7 meters is projected to result in an economic impact of between 3 and 15 percent of GDP due to lost agricultural production, tourism and fisheries and infrastructure damage (Asia Development Bank, 2013). These figures compare with projections for market and nonmarket losses and damages for the global economy ranging from 1 to 4 percent of output for a 4°C increase in global mean temperature.22

21. Climate change-related stress is projected to boost poverty and emigration. Low income communities are particularly vulnerable to climate change because of heavy reliance on agricultural incomes, a high proportion of incomes devoted to food items, and limited access to savings or credit to weather climate-related shocks. Economic vulnerability is matched by risks to health and other social indicators. Globally, climate change could push more than 100 million people into poverty by 2030 (Hallegatte et al., 2015). As climate change has a progressive impact on incomes, job opportunities, and living conditions (Khonje, 2015), emigration is likely to increase further—already twice that for larger countries and rising since the early-2000s (Figure 3).

Figure 3.
Figure 3.

Migration from Small Developing States

Citation: Policy Papers 2016, 038; 10.5089/9781498345095.007.A001

Source: United Nations.

Policy Responses to Natural Disasters and Climate Change

Much can be done to reduce the human and economic costs of climate change and natural disasters, alleviate output losses, and ultimately improve growth potential for small states. This section focuses on the need to extend macroeconomic policy advice and analytical frameworks to address the specific challenges associated with natural disasters and climate change.23

A. Introduction

22. Public policies can play an important role in building resilience to natural disasters and climate change. While weather events may be unavoidable, human and economic damages can be reduced by policies to improve preparedness and strengthen countries’ ability to bounce back from disasters and withstand global warming. A well-developed literature on policy frameworks for preparedness and resilience-building is actively promoted by the World Bank, UN, and other organizations. The frameworks emphasize readiness and contingency planning, risk reduction investments (both to strengthen physical infrastructure and to make financial risks tolerable), and appropriate regulations (for instance, for safe zoning and a supportive business climate) within a coherent long-term plan for economic resilience. However, the success of such plans will depend on their consistency with macro-stability and sustainability.

23. The immediate issue for Fund advice is how best to align macro, fiscal, and financial policies to support resilience-building while maintaining stability and sustainability. In the coming years, a more fundamental reassessment of macroeconomic policies as part of a national survival strategy will be necessary for small states facing an existential threat from climate change and sea level rise. This challenge goes beyond the scope of this paper, but the Fund will in future need to play a central role in helping at-risk countries explore their long-term macro-options.

24. Planning for disasters and a more difficult physical environment should be mainstreamed. Countries should explicitly build disaster and climate change into fiscal and other policy frameworks—including into budget design, public investment planning, and debt and asset management. This integration process should span the following elements:24

  • Identification and quantification. Steps are needed to identify and quantify the main disaster or climate change risks, their likelihood of realization, potential impacts, and key vulnerabilities (infrastructures at risk, vulnerable communities and populations).

  • Invest in risk reduction. Guided by risk assessments, decisions should be taken on whether and how to invest in risk reduction.

  • Develop contingency plans. Where risks cannot be mitigated, contingency plans for disaster response are needed.

  • Arrange contingency financing. Contingency plans for financing disaster relief and recovery should include self-insurance (fiscal reserves and contingency funds), contingent plans for disaster response using borrowed or grant resources, and risk-transfer arrangements using insurance or other capital market options.

25. Typically, considerable progress is needed to strengthen disaster risk management planning. While the above elements are intuitively straightforward, implementation tends to fall short. Analytical studies point to underinvestment in risk reduction across different countries despite calculated high rates of return on marginal projects.25 Clarke and Dercon (2016) cite multiple examples of flawed disaster response in both advanced and developing countries attributed to inadequate contingency planning, problems in coordinating responses across multiple partners (local and national governments, disaster relief agencies, foreign governments, etc.), and lack of access to necessary financing.

26. Political and other obstacles may need to be addressed. Clarke and Dercon (2016) highlight key challenges for disaster risk planning. Some relate to the professional requirements for good planning, e.g., scientific expertise in forecasting and modelling disasters or administrative skill in policy coordination. Important obstacles also relate to the politics of disaster risk management. Studies ranging from India to the United States suggest that politicians receive higher electoral rewards for responding to disasters “after the event” than for investing in risk reduction before disasters strike. This is partly because disaster response is more newsworthy than risk reduction, and partly because a program of preventive investments may span multiple administrations with “ownership” that is difficult to attribute. Experience also points to strong administrative and political preferences to retain discretion in responding to events, rather than to commit to ex ante plans—even if discretion is at the cost of speedy and effective response. Clarke and Dercon (2016) argue that a combination of sound professional advice, including from international organizations such as the Fund, and strong domestic leadership are needed to overcome these obstacles. Financing can also be a major hurdle, especially for small states, where spending on disaster risk reduction has to compete for scarce resources with other public services and with the need to maintain cash buffers for responding to disasters and other shocks.

27. Disaster risk management approaches will differ across countries. Steps to implement the disaster risk management framework are explored in more detail below, along with the respective role of the Fund. Since each country faces different risks and vulnerabilities, national preferences will dictate different social and economic priorities and institutional arrangements.26 Accordingly, policy advice should be tailored to country circumstances. The approaches outlined below have been developed specifically with a view to the needs of small states, but will apply in most cases also to larger countries facing risks from natural disasters and climate change. Annex III provides a case study of Vanuatu, exploring the impact of the highly destructive cyclone Pam in 2015 and the resultant policy lessons.

28. Fund engagement should be within its areas of macroeconomic competence. As discussed below, macroeconomic policies and institutions within the Fund’s areas of expertise play an important role in preparing for and responding to natural disasters and climate change. At the same time, many policies also important for reducing the macroeconomic impact of disasters and climate change are outside the Fund’s areas of competence, and Fund staff should collaborate closely with other organizations, such as the World Bank, to develop a full assessment of the adequacy of country policies.

29. The Fund’s tools for assessing risks and vulnerabilities need to be adjusted to incorporate natural disasters. Approaches for integrating natural disasters and climate change risks into standard Fund analysis are discussed in Annex IV with key messages summarized in Box 4. This advice builds on past work on small states, where staff have often explicitly integrated risks and vulnerabilities from natural disasters into projections and policy advice. That said, there has been considerable variance in approaches across countries and there appears to be scope to draw on good practice approaches in a more standardized manner.

B. Identifying Risks and Vulnerabilities

30. The Fund should identify risks and vulnerabilities and ensure they are appropriately reflected in macroeconomic policy frameworks. Disaster planning rests on a clear understanding of risks and vulnerabilities, the latter typically identified by national experts or international partners such as the World Bank and UNDP.27 Based on the specific risks facing particular countries, the Fund can advise on relevant policy responses. Transparent communication is important.

Integrating Natural Disasters and Climate Change into IMF Macro-frameworks and Risk Analysis

  • Macro criticality. In countries where natural disasters and climate change significantly affect economic performance, Fund analysis (of the macro framework, debt sustainability, external imbalances, etc.) should make specific allowance, whether in the short- or medium- to long-term.

  • Data sources and perspectives. Staff will usually need to combine EM-DAT data, country economic data, and perspectives from country experts to develop a full picture of the potential scale, frequency, and macro transmission channels of natural disasters and climate change. The assumptions adopted for analytical purposes should be clearly documented.

  • Macro baselines. Medium- to long-term baselines used for assessing policy sustainability (e.g., DSAs) should reflect economic performance not just in good years, but also factoring in the economic impact of future natural disasters. A range of approaches can be used to reflect the “average impact” of disasters, including using historic averages for key variables to develop tailored adjustments based on assumed risks and transmission channels.

  • Alternative shocks scenarios. The policy implications of adverse scenarios should be assessed. Risks around the baseline and the adequacy of fiscal and external buffers should be evaluated using alternative scenarios calibrated to reflect “average” and/or “tail risk” natural disasters.

  • Financial risks, reserve adequacy, and GE modeling. Tailored approaches can be used to explore financial sector risks, following practices applied in recent FSAPs. The current reserve adequacy tool can be readily adjusted to reflect the impact of natural disasters. And the Debt, Investment, and Growth (DIG) model could be used to explore the dynamic adjustment path following a disaster (see Annex V).

31. Preparation of a fiscal risk statement is a key element of Fund guidance on macro risk management. For countries where natural disasters are important, the risk statement should cover associated risks; this should be presented together with the budget to guide budget discussions.28 The Fund gives TA to countries to develop fiscal risk statements and has also created a fiscal transparency code and evaluation that covers risks from natural disasters.29 More broadly, the Fund recommends that risk management be undertaken within a comprehensive PFM framework covering risk assessment, self-insurance, and risk reduction and transfer (Box 5).

32. Sound macroeconomic data are key for assessing risks and developing policy responses. Given the limited capacity of many small states’ statistical agencies, Fund capacity building will be important across a broad range of sectors (national accounts, fiscal and external accounts, financial sector) and would span issues of methodology, data collection, and compilation. Regional collaboration on macroeconomic data compilation may be an option for some small states.

Fiscal Risk Management and Fiscal Risk Statements

Risk identification is important for fiscal transparency. The IMF’s Fiscal Transparency Code defines twelve major risks including natural disasters, and specifies that countries should analyze, disclose, and manage their potential fiscal exposure to such disasters. It indicates that management of these risks should be based in a published strategy.

Fiscal risks statements (FRS). These are reports prepared by the government at the time of budget preparation to inform the legislature and civil society about the most relevant fiscal risks and how the government plans to address them. The report, usually prepared by the ministry of finance in coordination with other agencies, should describe and quantify the main fiscal risks, discuss their likelihood, and propose fiscal measures to mitigate and manage them. Countries such as the Philippines, Indonesia, and New Zealand have detailed FRS that cover disasters. For example, the Philippines created a pre-disaster risk assessment, developed a catastrophe risk insurance facility for local governments, and incentivized local governments to pool calamity funds.

Framework for managing fiscal risks. Fiscal risk management should follow the broad policy approach in paragraph 24. Fiscal exposure to disaster risks should be identified and quantified in the fiscal risk statement. The statement should guide policymakers and the public toward risk-management priorities by detailing quantifiable and unquantifiable contingent liabilities and whether these are considered probable, possible or remote. Then, mitigation steps should be taken to reduce fiscal exposure, either as part of the budget or during the fiscal year (e.g., public infrastructure investment, tax incentives to encourage resilience-building behavior, or regulatory intervention—see Box 6). Contingency plans should be specified for risks that cannot be mitigated. For example, procedures to allow rapid release of funds in the wake of a natural disaster should be put in place in advance. Contingency financing should be identified in advance to the extent possible, as discussed in more detail in the section on financing (see IMF, 2016a for further details).

C. Investing in Risk Reduction

33. A risk reduction program to address identified vulnerabilities should be developed. Besides the development of information campaigns to increase preparedness, early warning systems, and contingency planning, risk reduction steps could involve public infrastructure projects, incentives to encourage private sector investments in risk reduction, and financial investment to offset risk. Some relevant options are enumerated in Box 6.

34. The Fund can help determine whether public investment is financeable and part of a coherent medium-term development plan. As discussed later in the paper, public spending on risk reduction needs to be consistent with fiscal space, debt sustainability, and macroeconomic absorptive capacity. This assessment depends, in part, on the projected economic returns from risk reduction programs. Staff are extending debt sustainability analysis on a case-by-case basis to reflect such returns.30 General equilibrium models such as the Fund’s Debt, Investment, and Growth (DIG) model provide a more comprehensive approach for exploring the impact of scaled-up investment on the macro-economy (see Annex V).

Risk Reduction Approaches

Public infrastructure programs. Stronger infrastructure could offer better protection against disasters. Examples include more effective seawalls along urban coastlines; maintenance or reinforcement of bridges; and investments in urban resilience (resilient construction and building back better).31

Public information provision. Accurate information about risks can influence decisions on where to locate and how to construct private commercial and residential properties.32 For example, risk maps on flood zones, areas at risk from coastal erosion, and landslide areas can provide valuable information to property investors. Where there is a developed insurance industry, this can help in setting terms and conditions for property cover. Information on disaster risk areas can also be used to tailor possible public insurance subsidies, with lower public contributions for high-risk areas. Adequate funding for public early warning systems is also important (e.g., hydro-meteorological and communication systems).

Property rights and regulation. Land use and zoning rules can reduce property exposed to disasters (e.g., by limiting building in flood plains) and building codes can ensure property strong enough to withstand disasters. Well-defined rights to own and lease properties create incentives to maintain property values. These can be fostered through affordable and effective land titling procedures and market-friendly rent controls.

Fiscal policies and pricing incentives. Targeted incentives could subsidize retrofitting properties to strengthen resilience (less costly to the tax base than a broad-based tax holiday to attract investors to a vulnerable country). Accelerated capital depreciation provisions also offer targeted incentives for investing in property. Fiscal incentives and appropriate pricing could also support more drought resilient crops, protect and expand forest coverage, and preserve scarce water resources.

35. Physical and financial investment in risk reduction (resilience-building) should be part of a well-prioritized public financial management (PFM) strategy.

  • All resilience-building public investments should be undertaken within the framework of each country’s comprehensive public investment program. While the Fund does not typically advise on specific investment priorities, it can help countries assess and build the strength of their public investment management framework using the Public Investment Management Assessment (PIMA). This provides a comprehensive diagnostic of a country’s current public investment practices and, based on this diagnostic, derives recommendations on how to raise efficiency (Box 7).33

  • Fiscal buffers should be accumulated via a saving strategy consistent with medium-term fiscal objectives (e.g., through the gradual accumulation of a rainy-day fund). The Fund should seek to ensure that spending and contingency allowances are integrated into a multi-year budget process. A consistent multi-year process may permit, for instance, contingency funds for emergency needs that remain unspent within a given year to be used for risk reduction measures the following year (as in Mexico and Vietnam). For small states, limited administrative skills and weak PFM systems may hamper the effectiveness of risk reduction efforts.34 In such cases, the Fund can play an important role in capacity building.

36. Regional approaches can be developed for risk reduction. Administrative economies of scale can be achieved by adopting regional regulatory standards or by establishing regional administrative bodies. Thus, in the Caribbean, the Caribbean Disaster Emergency Management Agency (CDEMA) coordinates regional disaster responses and establish codes of good practice, including for building construction. 35

37. More diverse income sources can contribute to reducing risks from natural disasters and climate change. Where small states have a highly-concentrated economic base (relying on agriculture, or tourism, say), it may be possible to develop new sources of income that are more resilient. For example, many small states have very large territorial waters, and Seychelles has pioneered the importance of the “blue economy” as a potential source of incomes and livelihood. The role of the Fund is less to identify potential new growth models than to advise on macroeconomic policies that may be needed for an effective transition (see IMF, 2014d).

D. Disaster Contingency Plans

38. Risk reduction activities should be combined with contingency plans for disaster response. Failure to plan ahead can seriously hamper the effectiveness of post-disaster intervention. Clarke and Dercon (2016) highlight the frequency with which public responses fall short because of delays in agreeing intervention priorities, time taken to resolve leadership and coordination issues across multiple levels of government and with foreign counterparts, and lack of short-term financing. They recommend establishing contingency plans for post-disaster action aligned with key risks and vulnerabilities. Thus, if droughts are a key risk, contingency plans could revolve around issues of food security and income support for farmers and pastoralists; if hurricanes are the main risk, plans could focus on emergency housing, compensation for the homeless, and restoration of key public infrastructures.

Improving Public Investment Efficiency with PIMA

The IMF’s Public Investment Management Assessment (PIMA) provides a comprehensive diagnostic of a country’s institutional capacity under 15 categories at three key stages of the public investment cycle: (i) investment planning, which covers, inter alia, fiscal rules, the management of PPPs, and regulation; (ii) investment allocation, examining the budgeting process (comprehensiveness, whether allocations are made multi-year) and project selection; and (iii) investment implementation, considering investment protection, the transparency of execution, and the availability of funding.

Following a 2015 report identifying average inefficiencies in public investment processes at around 30 percent, the Fund has been deploying this assessment tool across several countries. In partnership with the World Bank, the diagnostic has been conducted in more than 15 pilot countries (see IMF, 2014a and 2015a).

39. To ensure rapid disaster response, discretion should be kept to a minimum. Rules for public intervention should be clearly defined (such as the size of payments to affected households), leadership responsibilities should be explicit, and programs should be triggered by clearly-defined criteria (e.g., hurricanes at or above a certain category). The contingency plan should also be aligned with incentives for the private sector to adopt risk reduction behaviors.

40. Social safety nets provide important contingency coverage. Disasters can lead to permanent harm for victims, especially children, where malnutrition can impair cognition, productivity, and lifetime earnings, and so timely assistance is critical. For effective disaster intervention, contingent plans should be in place to scale up existing safety nets (World Bank, 2016c). The design of new programs after a disaster is declared may not allow for sufficiently prompt intervention.36 Cash transfers or vouchers are increasingly preferred where local markets can meet needs, because, unlike food aid, they offer greater choice and flexibility and stimulate domestic supply (Box 8). By contrast, research shows that large inflows of food and clothing aid can disrupt the value chain and undermine the livelihoods of merchants and other local businesses, especially in very small economies. These effects can be worsened by the monetization of aid, or corruption in distribution. Public works programs can also play an important role in providing post-disaster income support, while helping with disaster recovery and rebuilding. In some countries, such programs may be more politically amenable than cash transfers. The scale of relief should, in general, be calibrated to immediate needs, without undermining incentives for a return to more normal labor market participation as part of economic recovery.

41. The Fund can support members by sharing country experience with safety nets. In general, policy choices about the goals of contingency financing plans would be nationally determined, while the Fund has experience in helping countries adopt and strengthen safety nets and create the necessary fiscal space. For additional technical advice on how to design schemes that are well-targeted and efficient, countries should draw on expertise in the World Bank and other relevant institutions. Given that budget constraints are a factor in safety net design, governments should explore with development partners the scope to use contingent financing arrangements to support disaster-related safety net programs.

42. Caution is needed in drawing on pension or provident funds to finance a safety net. Following cyclone Pam, the Vanuatu National Provident Fund (VNPF) allowed its 40,000 active members (mostly civil servants) to withdraw up to 30 percent of their pension fund to cover cyclone-related expenses. Although this successfully provided financing equivalent to 2 percent of GDP over a three-month period, most members were located on less-affected islands and a significant fraction of the withdrawals was likely used for non-disaster purposes (there was no monitoring of funds usage). The drawdown left the VNPF illiquid and less able to finance pension needs. In Fiji, similar concerns arose when public pension fund assets were used to cover disaster recovery needs.

43. The Fund can also advise on the design of budget laws to ensure that budget systems continue to function after a disaster. The legal framework should ensure sufficient spending flexibility to cope with natural disasters, including by: (i) provisions in organic budget laws allowing the government to exceed spending limits up to a defined amount in the event of a formally declared natural disaster; (ii) escape clause provisions in any fiscal responsibility laws to allow the government to break the numerical or procedural targets in case of a major natural disaster; (iii) provision in the annual budget law giving the necessary flexibility to the government to shift resources in case of a major natural disaster; and (iv) establishment of contingency space in the budget to cope with emergency needs (IMF, 2012b). The appropriate approach will depend on the PFM legal tradition in any given country.

E. Fiscal Policies and Debt Sustainability

A range of fiscal institutions and policies are relevant for managing the macroeconomic vulnerabilities posed by natural disasters and climate change. These span PFM and debt management practices, carbon taxation and energy pricing reform, and approaches for achieving fiscal and debt sustainability.

Examples of Disaster-Related Safety Nets

Fiji. In the immediate aftermath of 2016 Tropical Cyclone Winston, the government focused on humanitarian and in-kind support (food, water, tents). After about one month, local markets became functional again, and the government made cash payments to vulnerable groups through the existing social welfare scheme benefitting about 22,800 households and 17,800 pensioners. An impact evaluation found that beneficiaries were faster to recover than non-beneficiaries and that the majority of assistance was spent on essential items. A final stage of support comprised the provision of housing vouchers (around 3–4 months after the cyclone).

Jamaica. Following Hurricane Dean in 2007, Jamaica made a supplemental transfer of around $28 to 90,000 beneficiaries under its established safety net scheme (PATH). In addition, based on assessments of property damage, it provided vouchers to households valued from US$280 to US$850 to purchase hardware supplies from local stores for home repair.

Maldives. A cash transfer system was developed after the 2004 tsunami and delivered to some 53,000 people—about a fifth of the population—within one month. Teams visited all the affected islands, confirmed the damage to houses, and on the next day paid the victims in cash (the equivalent of $40-$115, depending on the damage).

Mauritius. To ensure transparency, post-disaster transfers were distributed in public meetings after assessing housing damage.

Pakistan. After a major earthquake, individuals and families were given a fixed amount for relief and to help rebuild their destroyed houses. Payments were channeled through bank accounts opened by beneficiaries.

Vanuatu. To support rebuilding, the government suspended VAT on building materials for 3 months in the aftermath of cyclone Pam.

Public finance and debt management

44. Policies for disaster risk management should be integrated into a sound budget framework. A sound PFM system is essential to enhancing risk management by incorporating disaster risks into fiscal planning. From a public financial management (PFM) perspective, risk reduction investments, contingency financing plans, and disaster financing approaches discussed above should be part of a top-down approach to budgeting under a transparent and sustainable medium-term fiscal framework (see IMF, 2009 and 2014b). The Fund should continue to play a leading role as provider of technical assistance on PFM practices in small developing states and other disaster-vulnerable countries (Box 9).

A Case Study on IMF Capacity Building on PFM Practices—Pacific Islands

PFM capacity building, designed to improve budget planning and enhance the transparency of public funds, helps the Pacific Islands (PICs) make a strong case for external assistance related to natural disasters and climate change.

Public financial management reform and more transparent aid management policies enhance the effectiveness and quality of public expenditure, thus offering benefits that extend beyond climate change and natural disaster risk management. A recent report by the Pacific Islands Forum (PIFS, 2013, Nauru case study) offers several lessons. These include the benefits of integrating climate change into national plans, policies and budgets, and of tracking spending through budget systems. The report also cites the difficulties in quantifying the extent of external financing available for climate change and distinguishing this financing from existing development assistance. These challenges are likely to divert capacity from other aspects of core policy management.

The Pacific Financial Technical Assistance Centre (PFTAC) also provided training to enhance Pacific islands’ disaster risk management capacity. PFTAC, in coordination with the World Bank’s Disaster Risk Financing and Insurance (DRFI) Program, delivered a March 2015 regional workshop hosted by the Pacific Islands Forum Secretariat on incorporating natural disaster risks into the fiscal planning process. The workshop addressed special budgetary procedures for providing rapid access to emergency funding; the macroeconomic and fiscal impact of natural disasters; how to incorporate disasters risks into the fiscal planning process, and elements of disaster risk financing.

45. Fund capacity building can also help small states strengthen public debt management in the aftermath of natural disasters. Thus, Vanuatu recently established a public debt management office as part of an emphasis on “building back better” following cyclone Pam. Specific liquidity management innovations could be introduced into domestic and external debt instruments to provide temporary cash flow relief (triggering deferral of debt service for qualifying natural disasters).

Carbon taxes and energy pricing

46. The Fund can advise small states on carbon taxation and energy pricing reform. Small states contribute little to global CO2 emissions and other greenhouse gases. Nonetheless, carbon taxes can help these countries make progress on their emissions commitments and provide an attractive source of revenue. For the 2015 Paris Agreement on climate change, 195 countries submitted emission reduction pledges—independently determined national contributions (INDCs). For example, Mauritius and Seychelles pledged to reduce their emissions by 30 and 20 percent, respectively, relative to business as usual emissions in 2030. Carbon taxes (or tax-like instruments) are the most efficient instruments for reducing emissions. They can also raise substantial new revenues and can be implemented through a straightforward extension of fuel taxes which are well established in most countries and amongst the easiest of taxes to administer. The Fiscal Affairs Department of the IMF has developed spreadsheet tools to quantify the level of carbon pricing needed in different countries, the environmental, fiscal, economic, and incidence impacts of these policies, and their trade-offs with other instruments. The IMF also provides country-level guidance on the broader reform of energy prices to reflect the full range of environmental impacts (e.g., air pollution, road congestion).

Fiscal and debt sustainability

47. Adequate fiscal buffers are a critical part of disaster contingency planning. As discussed in the next section, domestic resources represent the first “layer” of potential disaster financing, providing immediate liquidity for disaster relief. Indeed, for small disasters, domestic deposit buffers may provide the only necessary financing. Once the appropriate size of the fiscal buffer has been established (see below), a first challenge for fiscal policy may be to accumulate additional savings if the current buffer falls short. This will require an assessment of how savings can be increased (additional revenue measures, savings on expenditures) and a timeline for the policy adjustment. The pace of accumulation of buffers should be considered from a cost-benefit assessment. Where priority spending would need to be cut to boost savings and build buffers, a more gradual accumulation of buffers could be considered drawing on new revenue measures. One option for building buffers is to include a sizeable provision for future natural disasters in the annual budget. In the event that a disaster does not occur, this allocation could be saved, thereby strengthening the fiscal buffer.

48. The fiscal stance should be set taking into account the need to build and maintain contingency buffers. In general, it may be necessary to “look through the cycle”, running a stronger fiscal stance in non-disaster years to accumulate buffers (in the form of savings or debt reduction) that can offset the adverse impact on public finances in future disaster events. The appropriate fiscal stance in non-disaster years will also depend on starting conditions. For example, the fiscal stance calibrated to provision adequately for the costs of future disasters may come on top of primary surpluses necessary to reduce a historically high debt burden. Care is needed to distinguish disaster-related and other random shocks from more permanent changes in fiscal conditions. The Fund can help countries disentangle the temporary disaster element which merits financing from more permanent fiscal shocks for which macroeconomic adjustment would be more appropriate.

49. Fiscal rules can provide the discipline needed to sustain buffers. For countries facing disaster risks, an appropriate rule could target an underlying fiscal balance during normal times that builds buffers and borrowing space. This could be accompanied by an escape clause that allows for larger fiscal deficits as part of the response to shocks such as natural disasters. The rule could also include a “debt brake” that requires fiscal adjustment in case of large ex-post slippages in fiscal balances and associated debt buildup. Where initial fiscal consolidation to reduce debt burdens is necessary, this should precede the introduction of a fiscal rule, thereby making the rule more credible, with the rule serving to lock-in these gains.

50. Debt sustainability assessments take on additional importance in disaster-vulnerable countries. Post-disaster recovery and rebuilding programs typically include a debt-financed element, and the amount and terms of such financing should be carefully reviewed. Experience suggests that rapid debt accumulation is not uncommon in countries experiencing a series of disasters. This may reflect a weak underlying fiscal stance, with disaster-related borrowing exacerbating already weak debt dynamics. It may also reflect looser scrutiny of borrowing plans in a post-disaster setting. DSAs should be based on assumptions about trend economic growth and the future fiscal stance that incorporate the risks of adverse shocks from further disasters over the projection period (Box 4 and Annex IV).

51. More adept debt management may also help strengthen fiscal buffers. The stock of existing debt and associated financing requirements may constrain the scale and terms of access to new financing for disaster response. In some cases, debt management approaches may improve credit access—for example, refinancing existing short-term obligations at longer maturities may provide potential for new short-term borrowing. In other cases, the overall debt burden (relative to GDP or revenues) may be excessive, and improved market access will require a sustained period of strengthened fiscal performance to reduce debt ratios and steps to deepen the domestic debt market.

F. Monetary Policy and Financial Sector Issues

Financial sector risks should be identified, and contingency plans adopted and communicated. Deep and well-regulated banking systems and developed capital markets are better able to withstand shocks and provide credit to aid post-disaster recovery.

52. The impact of natural disasters on inflation should be considered in setting monetary conditions. While natural disasters have a negligible impact on inflation in advanced economies, they can have an impact lasting several years in developing countries (Parker, 2016). For the latter, storms can boost food price inflation for up to a year, while earthquakes tend to reduce CPI inflation excluding food, housing, and energy. A good understanding of these effects can help in setting policy in the immediate aftermath of a disaster.

53. The financial sector should be incentivized to support economies through disasters and develop risk-management instruments. For small states, this requires, first, identifying financial sector risks and adopting and communicating contingency plans. Over time, reforms to improve regulations and financial deepening will leave the sector better able to withstand shocks and provide credit to aid post-disaster recovery. Ideally, the financial system would also provide insurance and hedging instruments, as well as financing for investment in risk reduction. However, scale inefficiencies in small states make it likely that these needs will continue to be provided externally.

54. FSAPs and FSSRs can help assess disaster risks. While only a limited number of Financial Sector Assessment Program (FSAP) reviews have been conducted by Bank-Fund teams for small states, they provide illustrative examples of how stress tests can be used to identify the financial risks associated with natural disasters, both for the banking system as well as for the insurance sector.37 The recently introduced Financial Sector Stability Reviews (FSSRs) have been developed as a new technical assistance instrument to help countries pursue financial inclusion and deepening in a manner complementary to financial stability. FSSRs have the potential to boost financial sector resilience to natural disasters through support for long-term financial sector development as well as short-term risk management frameworks (see below).

55. Crisis management strategies and contingency plans should be tailored to identified risks. Disaster risk management strategies can draw on Fund FSAPs and other capacity building on financial crisis preparedness and safety nets. The strategy should be tested in crisis simulations, and financial institutions and the public should be informed about the plans and tools available to handle a crisis.

  • Infrastructure. Key immediate goals are to ensure continued access to the banking system, continuity of the payment system, and ability to conduct cash transfers. Continued access to microfinance and mobile banking can also help in conducting financial transactions after a disaster.38 Where there is a developed local insurance sector, it should have infrastructure in place to allow prompt response in the event of a disaster.

  • Institutions. The strategy should define the responsibilities and actions of key institutions (usually the central bank, ministry of finance, regulatory authorities, and parliament) and establish plans for contingency financial sector response and recovery. Public lending institutions may be expected to play a role in financing the recovery, though risks should be carefully considered.39

56. Longer-term planning should target financial deepening and building financial resilience.

  • Steps to improve financial access can help countries weather disasters, as can longer term efforts to develop insurance and capital markets. Resilient mobile banking and microfinance networks should also be developed to supplement the traditional banking system for cash transfer after a disaster, and to support remittances, which are always an important source of incomes in small states and can be augmented when there is an urgent need.40 The development of private insurance should be a priority, either domestically or through regional or international arrangements. More developed financial systems may also be able to finance public interventions or restructure obligations more easily in a post-disaster setting.

  • Strong regulatory and supervisory frameworks can make banking systems more resilient to shocks. Disasters can undermine loan performance, resulting in financial stress. Financial crisis preparedness/safety nets, including a solid bank resolution framework and a deposit insurance scheme, should be strengthened in advance of natural disasters. For small states with limited supervisory capacity, the focus should be on the basics (such as access to financial data, and conducting off- and on-site supervision).

57. Higher prudential capital and liquidity ratios may be appropriate for disaster-vulnerable countries. Developing and running stress tests would help determine suitable macro-prudential measures to address liquidity stresses, which may be more acute for smaller countries. The regulator would need to balance various factors such as profitability, capital adequacy, non-performing loans (NPLs), deposit growth, and overall growth in the economy with the potential impact of disaster risks on the economy and the financial sector.

G. External Sector Policies

58. The assessment of appropriate external buffers should take account of key features of small states. The impact of disasters on the balance of payments of small states is proportionately higher as a share of GDP. In addition, most small states have fixed exchange rate arrangements. These two factors suggest that the optimal level of reserve cover is likely to be higher than for other economies. A natural disaster will likely increase demand for foreign currency that will require substantial intervention to support the pegs. Even in states with flexible exchange rate rates, a higher level of reserves will help prevent disorderly foreign exchange market developments.

59. Standard reserve adequacy metrics often do not factor in the risk/ impact of disasters and underestimate reserve needs for countries susceptible to natural disasters. The metric for reserve adequacy developed by Mwase (2012) for small states takes into account countries’ susceptibility to natural disasters.41 The metric places a greater weight on short-term debt and exports than for other countries, reflecting the higher vulnerability of small islands to terms-of-trade shocks and the limited financial structures that could lead to accelerated deleveraging for countries without short-term market debt. Thus, the metric requires higher reserve holdings than would normally be assessed to reduce the probability of a crisis (i.e., minimizing the probability that a shock leads to a crisis). This framework could be applied, tailored to the specific circumstances of different small states.42 Further analysis is also warranted regarding the appropriate reserve buffers for disaster-affected countries. Based on a sample of countries, small states do not appear to significantly draw on reserves following disasters to finance balance of payments needs (Annex VII, Figure 2). One possibility is, that with limited reserve buffers, imports are delayed until external financing can be mobilized.

60. Pooling of reserves at the regional level may help reduce the costs of preparing for natural disasters. It allows members to share risk, thereby lowering the level of reserves that each country needs to maintain. Such pooling of reserves--as in the case of the Latin American International Reserve Fund (FLAR) and the Chiang Mai Initiative (CMI) in East Asia--offers a way to deal with idiosyncratic shocks, such as with natural disasters.43 Pooling international reserves allow members to benefit from economies of scale, thereby reducing the cost of natural disaster insurance premiums.44 It also reduces the need for excessive reserves hoarding owing to incentives to avoid resort to official financing. Transfers from the regional reserve pool following a natural disaster would also allow for a faster recovery, a cushion to the balance of payments, and can even mitigate capital outflows by instilling confidence. The main drawback to such a mechanism is moral hazard and sovereign risk concerns associated with risk sharing across countries.

Financing Approaches

61. This section discusses financing needs related to natural disasters and climate change.45 It opens by exploring current practices for financing natural disasters, optimal approaches, and obstacles to the latter. This is followed by a detailed discussion of several key financing options, with specific recommendations for usage. The section concludes with a discussion of access to climate change financing for small states.

A. Financing Natural Disasters

Countries should develop advance plans for financing natural disasters, rather than looking at options only “after the event”. Advance plans should comprise a mix of fiscal buffers, contingent grant and loan arrangements, and risk transfer options. Limited progress has been made in this direction, and large disasters tend to be under-financed for small states, despite the relatively small cost by global standards.

62. Natural disasters give rise to several financing needs. Prior to disasters, financing should be allocated to a program of risk reduction investments. When disasters strike, financing is needed for relief and recovery. Then, longer-term financing is needed for rebuilding. Each of these elements of financing should be integrated into the fiscal and debt management frameworks.

63. Uncertainty is the biggest challenge, so ex-ante risk reduction should be a priority. The main challenge is how to provision for urgent post-disaster relief and recovery costs that are, by their nature, unpredictable and require financing that was not envisaged in the budget process. Rebuilding needs in the aftermath of a disaster are similarly difficult to predict. Risk reduction investments, on the other hand, are predictable and can be integrated in a straightforward manner into the medium-term fiscal framework. There is a strong case for expanding ex ante risk reduction investment to a far greater extent than currently, since not only can this type of financing be managed with more predictability, but—more fundamentally—the greater a country’s success with risk reduction, the lower its expected damages that will need ex-post financing.

64. Currently, however, small states’ disaster financing is almost exclusively focused on ex-post recovery rather than on ex-ante risk reduction. Governments face constraints on domestic and external resources, and difficulties in accessing financial instruments at costs that seem affordable. Hence they continue to rely on ex-post borrowing and support from the international community to pay for rebuilding. The result is underinvestment in adaptation and risk reduction as well as a slow, fragmented, and unreliable response to natural disasters (Clarke, 2016). Data on overseas development assistance (ODA) point to a clear ex-post emphasis. During 1990–2010, emergency response and reconstruction accounted for 86 percent of disaster-related ODA disbursements, with disaster prevention and preparedness representing only 14 percent46 For small developing states, the latter proportion was only slightly higher (24 percent). ODA financing is also less than fully additional. There is also evidence that, in the aftermath of a disaster, external development partners reassign previously allocated funding, implying a reprogramming of spending priorities.47 While this may be an efficient use of resources, it can overstate the country’s access to net new financing. Moreover, it implies a tradeoff between disaster recovery and the developmental goals that would otherwise have been financed.

65. The World Bank has developed a risk-layered framework for optimizing disaster financing. Given a country’s disaster risk, policy makers should choose a mix of financial instruments that finances their contingent liability at the lowest economic opportunity cost (Clarke et al. 2016). The model balances the speed of access to post-disaster resources with the cost and potential availability of financing (Figure 4).

  • Small disasters. Small but unpredictable financing needs can be met using self-insurance— either by reallocating spending or drawing down available government deposits. This can provide resources quickly and at a lower cost than via sovereign insurance.

  • Moderate sized disasters. Financing needs will typically exceed buffers available from self-insurance, and will require access to external resources. Since external grants and loans are often difficult to mobilize at short notice, efforts should be made to establish contingent arrangements that provide access to resources in the event of a disaster. For moderate and large disasters, risk transfer options should also be developed, whereby a third party takes over a portion of disaster-related financial risks in exchange for a fee or premium.

  • Largest disasters. In these cases, large-scale insurance is not cost-effective, but catastrophe adjusters in sovereign bonds can allow some risk transfer in the form of debt service savings.48 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, though financing flows are often slow and unpredictable.

Figure 4.
Figure 4.

Disaster Financing Risk Layering Model

Citation: Policy Papers 2016, 038; 10.5089/9781498345095.007.A001

Source: IMF, based on Clarke and Dercon, 2016.

66. Actual practice suggests some degree of optimization of disaster financing. For this paper, sources of financing were examined for 24 disasters of different sizes affecting small developing states in 1995–2015 (Table 4 and Annex VII). Data were compiled on the amount of disaster damages (EM-DAT database) as well as the estimated sources of fiscal and balance of payments financing.49 The results suggest some degree of risk layering of financing. For the smallest disasters, financing appears to come from internal resources, as recommended by the risk layering model, since there is no identified increase in external financing.50 For medium-sized disasters, there is a clearer diversification of financing sources—involving both domestic bank credits as well as external grant and loan financing. For the largest disasters, there is less use of domestic bank financing, and more exclusive reliance on external resources—including the use of remittances by the private sector.51 This country survey suggests that small states have access to sufficient external financing to cover mid-sized but not the largest disasters. In the latter case, new external financing over a three-year period covered less than half of the estimated disaster losses. This suggests that recovery from the largest disasters is either typically incomplete, or a process that stretches well beyond three years, implying extended costs from sub-par infrastructure.

Table 4.

Sources of Post-Disaster Fiscal and BOP Financing

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Sources: IMF and EM-DAT data.

Balance of payments data provided information on reserve drawdown and remittances; fiscal data provided information on domestic bank financing; and fiscal and BOP data provided information on external grant and loan financing.

Cumulative change in annual average financing for disaster year and three following years compared to the annual average financing three years prior to the disaster. The over-financing of middle-range disasters is due to one outlier (Seychelles).

B. Risk Financing Toolkit

67. The Fund can assist countries to identify disaster-related financing needs. This could involve quantifying financing needs, based on an analysis of disaster risks and vulnerabilities and their possible fiscal impact. Financing needs could be segmented by date, distinguishing urgent financing needs (under 3 months), short term needs (under 1 year), and medium term needs (over 1 year). This would help to identify the necessary scale of fiscal buffers, access to financing, and/or risk transfer arrangements. The following paragraphs explore the different elements of the disaster risk financing tool kit in more detail.

Domestic financing and deposit buffers

Government deposits and access to domestic bank financing provide buffers for shocks, but have financial sector liquidity implications that need to be managed. They are best suited for less costly disasters.

68. Central and commercial bank financing may provide a limited buffer against shocks. Where small states have a central bank with authority to provide budgetary financing, this may represent one option, albeit limited, for disaster-related financing. In general, central bank financing of the budget should be strictly limited on account of risks of fiscal dominance that could undermine monetary policy effectiveness. Disaster-related spending should also compete on an even-footing for fiscal resources, and should not have “special” access to central bank financing. Scope to borrow from domestic commercial banks is also likely to be limited, as liquidity in the system may not be adequate to provide additional fiscal financing at a time when the banking system faces other financing and liquidity needs on account of the disaster. Overall, domestic borrowing is likely to be most useful in the context of small-scale disasters.

69. Government deposit buffers provide an alternative to domestic borrowing. In principle, such buffers are designed to cover early disaster response needs without compressing other priority spending until other sources can be mobilized. In some disaster-vulnerable countries in the Pacific, governments aim to maintain a deposit buffer equivalent to 3 months of recurrent spending. This buffer could, in principle, take the form of deposits in the government’s general fund, a “virtual” contingency fund within the general fund, or a dedicated fund for natural disasters. The Fund can advise on the design and management of deposit buffers and the use of dedicated contingency funds (Annex VIII). An important general consideration is that the drawdown of deposit buffers within the banking system will have similar liquidity implications as government borrowing that will need to be managed. Where current deposit buffers are inadequate, the Fund can advise on strategies for accumulating assets.52 As noted in the fiscal policy discussion, the timeline for building adequate buffers may depend on broader fiscal constraints, and would need to be specified consistently with the country’s public investment and debt and asset management strategies, given the trade-off between building buffers, capital spending, and reducing debt burdens.

External borrowing and insurance

Contingent lines of credit help reduce ex ante disaster financing uncertainty, while insurance products allow for risk transfer, at a cost.

70. Contingent lines of credit reduce external financing uncertainties. Financing can be slow to arrange, particularly if markets perceive the disaster as having increased credit risks.53 For these reasons, Clarke and Dercon (2016) argue for ex ante financing agreements that can be mobilized in the event of a disaster. Contingent financing arrangements can be arranged with bilateral, multilateral, and commercial creditors. At a bilateral level, for example, the Marshall Islands, Micronesia, and Palau benefit from compact agreements with the United States offering access to emergency support from relevant U.S. agencies, notably the Federal Emergency Management Agency (FEMA) and the United States Agency for International Development (USAID).54 At the multilateral level, the World Bank’s CAT DDO offers a pre-approved line of credit for countries experiencing disasters. Currently, this instrument is available only for middle income countries, and the Seychelles is the only small state that has negotiated coverage.55 The World Bank, with G20 financing, also recently established a Pandemic Emergency Financing Facility which could serve as a good model for natural disaster financing. The facility protects poor countries against pandemics using catastrophe bonds, reinsurance, and a cash window. Financing under the IMF’s RCF and RFI are not fully contingent, in that they are subject to conditions for access;56 however, the fact that these do not entail a Fund-supported program helps facilitate rapid disbursement. One downside to contingent credit is that the ex-ante fiscal costs of disaster relief remain uncertain and, even on an ex post basis, the fiscal impact is deferred until debt service falls due.

71. More clarity in budgeting can be provided through insurance and other risk transfer arrangements. By insuring public assets, governments can reduce uncertainties associated with direct exposure to disaster risks. Similarly, encouraging insurance of private property reduces the risk that the public sector will be called on to cover private losses. Empirical research has shown that countries with more private and public insurance penetration experience far lower output and income losses from disasters.57 Prompt insurance compensation reduces downtime for productive assets, reduces disruption of infrastructure, and indemnifies producers for income losses. The research suggests that countries with relatively low insurance penetration stand to benefit the most because they have relatively more unprotected earning assets compared to countries nearing saturation. However, uptake of insurance coverage should reflect cost-benefit considerations. For disaster financing in Ethiopia, Clarke and Dercon (2016) show that a financing strategy that includes insurance is far less costly than other options when disasters are large (i.e., 1-in-30 year events), but this advantage declines with smaller, more common events. Similarly, Bevan and Adam (2016) show that insurance is less costly than tax increases and expenditure reallocation for some disasters.

72. Traditional indemnity insurance of physical assets is not widespread in small states. The cost of indemnity insurance is high, especially where markets are underdeveloped and competition is limited.58 High premiums can also reflect the high probability and cost of disasters in small states. As a result, uptake is low, with premium payments for non-life cover averaging just 1 percent of GDP for typical small states. That said, Belize and Grenada rely on traditional insurance against severe natural disasters. In Grenada this covered about 4.5 percent of total damages (9.2 percent of GDP) in a recent large disaster. There is some evidence from developing countries that traditional insurance for disasters has been more successful and sustainable under public-private partnerships than under exclusively private or public options. In considering this option, contingent risks to the budget would need to be carefully monitored. At the same time, the private market can be supported through better regulation and supervision, and there may be a role for some level of mandatory catastrophe insurance.59

73. Innovative approaches for sharing natural disaster risks have emerged over the past decade. Parametric insurance has emerged as a complement to regular indemnity insurance. Rather than covering specific physical assets, it is effectively an options contract that pays out in the event of a disaster that exceeds a pre-specified severity. Triggers for payout can be specified, for example, in terms of storm, flood, or earthquake intensity (measured according to third party data). Parametric insurance is quick-disbursing, but costs can be high because the market for cover is still developing. In some cases, economies of scale have been achieved by pooling cover at a regional level. A second innovation has been the development of catastrophe (CAT) bonds, which are issued as financing instruments by disaster-vulnerable countries. In exchange for a generous coupon payment, investors agree to forgive the bond principal in the event of a disaster (as measured by a parametric trigger). This releases resources from debt service to finance disaster response. Further details on these approaches are provided in Annex IX.

74. The Fund can support insurance development in several ways. Technical assistance on debt management strategies could be extended to include approaches for assessing the optimal mix of debt and insurance instruments. Since insurance is an alternative to debt-financing of disaster relief, countries need to understand how to balance debt against insurance (i.e., risk retention against risk transfer). This involves adopting a framework that weighs the costs of borrowing (debt service costs, market access risks) against the costs of insurance (insurance premia, basis risk). By helping countries better understand these tradeoffs, Fund expertise would help countries decide on what type and level of insurance coverage to purchase. The Fund can also help identify approaches to promote sustainable development and oversight of private insurance markets, including through FSAPs and FSSRs. A deeper dialogue with the insurance industry would make the Fund contribution more effective in this area.

C. Climate Change Financing

Small states have begun to access global climate funds, but their needs remain under-funded by as much as $1 billion annually. Moreover, available financing is biased toward mitigation (reducing greenhouse gas emissions) rather than adaptation needs (adjusting to the impact of climate change). Access to climate change financing is complex and administratively cumbersome, hampering access by small states with weak capacity.

75. Estimated global financing for climate change currently approaches $400 billion annually. According to the most comprehensive source, cumulative financing (public and private) reached US$391 billion in 2014 (Figure 5). The private sector accounts for the largest share, with investments predominantly in carbon emissions mitigation in advanced and emerging countries. However, data on climate change financing are subject to a large degree of uncertainty. The architecture of climate finance is complex and evolving rapidly with a multiplicity of initiatives. International financial institutions, multilateral mechanisms, and climate funds operate side by side with national development assistance agencies, bilateral and national funds. The fragmentation of financing sources hampers the consistency and quality of data as different entities report according to their own definition, level of detail, frequency, and with different quality control procedures.60 Despite recent efforts to improve the situation, significant data gaps remain, particularly for private financing and public financing that is not channeled through multilateral or national development banks. 61

Figure 5.
Figure 5.

Global Climate Finance Flows (2014, US$ billions)

Citation: Policy Papers 2016, 038; 10.5089/9781498345095.007.A001

Source: Climate Policy Initiative (2016)

76. Developed countries have committed to jointly mobilizing US$100 billion of climate change financing for developing countries by 2020. In the 2009 Copenhagen Conference of Parties (COP15) to the United Nations Framework Convention on Climate Change (UNFCCC), developed countries agreed that this amount should be raised each year from both public and private sources with a balanced allocation between mitigation (reducing greenhouse gas emissions) and adaptation (adjusting to the impact of climate change). The 2010 Cancun Conference (COP16) affirmed a clear priority for adaptation finance to the most vulnerable developing countries. The commitment to the US$100 billion goal was strengthened at the 2015 Paris conference (COP21), with a concrete roadmap agreed upon by 38 advanced countries to help developing countries to develop and implement mitigation contributions and adaptation plans, scale-up climate finance and significantly increase finance for adaptation.62

77. A rough estimate suggests that financing for low-income countries has reached the $50–60 billion range. Based on data compiled by the OECD and Climate Policy Initiative, financing flows increased from $52 billion in 2013 to $62 billion in 2014 (Figure 6). Official bilateral and multilateral sources comprise around 70 percent of the total, the majority in the form of grants and concessional loans. Based on current commitments, OECD projections suggest that financing flows could approach $100 billion by 2020.63

Figure 6:
Figure 6:

Progress Toward the S$100 Billion Goal, 2013–14

(US$ billion)

Citation: Policy Papers 2016, 038; 10.5089/9781498345095.007.A001

Source: OECD-CPI, 2015, Climate Finance in 2013–14 and the USD 100 Billion Goal.

78. Climate change financing for small developing states is also growing, but from a low base. Climate finance increased significantly after COP15, but the overall amount remains small, reaching less than US$1 billion in 2014 (Table 5). Multilateral development banks play a key role, having channeled $444 million to small states in 2014.64 In the same year, direct assistance from bilateral donors amounted to US$368 million while US$140 were provided by dedicated multilateral and bilateral climate funds.65

Table 5.

Climate Change Financing to Small Developing States – 2014

(US$ millions)

article image

Data for the 39 members of the Alliance of Small Island States (AOSIS).

Source: IMF staff elaborations on OECD DAC and ODI-Climate Finance Update databases and AfDB, ADB, EBRD, IDB, IFC, and WB (2016a).

79. A majority of small states financing is for climate change mitigation, falling short of adaptation needs. Although COP16 placed increased emphasis on adaptation for low-income and small developing countries, mitigation still accounts for some 58 percent of total climate change financing for small developing states. According to the most recent estimates, global adaptation costs are 2 to 3 times higher than international public finance available for this purpose and to close this gap adaptation finance would have to be between 6 to 13 times larger by 2030 (United Nations, 2016). For small states, in 2010 the World Bank estimated a shortfall in annual adaptation financing relative to their needs of about $800 million (Margulis and Narain, 2010). Of this shortfall, 66 percent was for Caribbean states, 27 percent for Pacific states, and 7 percent for Africa and the Indian Ocean. Adaptation priorities vary across small states, with the infrastructure representing the largest cost, and expected to increase over time with urbanization. Other priorities include investments in coastal zones, water supplies, agriculture, human health, and preparedness for extreme weather events.

80. Additionality of climate change financing is a concern for small developing states. Bilateral and multilateral climate finance may crowd out pre-existing commitments. Indeed, over the last decade, bilateral climate finance to small developing states has increased more rapidly than overall official development assistance (Figure 7). Projections suggest that aid to these countries will stagnate at current levels going forward. Moreover, in addition to the data issues mentioned above, tracking progress toward the US$100 billion goal is complicated by the difficulty to distinguish between resources made available by donors under previous commitments and new and additional resources.

Figure 7.
Figure 7.

Small developing states’ share of ODA flows

(percent)

Citation: Policy Papers 2016, 038; 10.5089/9781498345095.007.A001

Source: IMF staff elaborations on OECD CRS database

81. Eligibility criteria for financing are complex and administratively cumbersome for small developing states. The multiplicity of funding sources and intermediaries has given origin to an equally fragmented set of criteria that regulate the flow of climate funds. While multilateral development banks have adopted broadly harmonized principles to guide eligibility and disbursement for climate-related projects, criteria for climate funds and bilateral initiatives vary markedly. Eligibility criteria for the main existing funds include: (i) being a party to the UNFCCC eligibility/Kyoto Protocol; (ii) eligibility for general financing/technical assistance from the institution (IFAD, World Bank, UNDP), including debt sustainability and macroeconomic context; (iii) consistency with the funding institution’s strategic objectives or themes/ specialization; (iv) consistency with national plans/strategies; and (v) recipient government’s commitment, etc. In many cases, applicants are required to have coherent national climate plans already in place. Fulfilling the conditions for access to available funds can be a challenge for small developing states with low capacity.66 While most governments and financing partners recognize the need for more effective coordination and partnership in climate change financing, efforts are at an early stage. A particular challenge is to adjust administrative procedures to the scale of small states’ funding needs.67

82. Strengthening administrative capacity will be critical for helping small developing states access climate change financing. Adequate administrative capacity is essential to coordinate domestic institutions to access, manage, and use climate finance in an effective manner. Indeed, small developing states with lower institutional capacity have less access to multilateral climate finance (Figure 8).68 Also, supporting policies may be necessary to promote adaptation efforts and governments can play an important role. Policy intervention can help overcome market failures and promote private sector adaptation. Key factors for an enabling domestic environment are stable domestic policies and consistent legal and regulatory frameworks. These factors can help attract and absorb international climate finance while ensuring the effective and accountable use of the funds.

Figure 8.
Figure 8.

Institutional Capacity and Access to Multilateral Climate Finance, 2003–2015

(US$ millions)

Citation: Policy Papers 2016, 038; 10.5089/9781498345095.007.A001

Source: IMF staff calculations on ODI-Climate Funds Update database and World Bank CPIA database. Based on 20 out of 34 small developing states with reported CPIA scores.

The Fund’s Role in Financing69

A. IMF Financing for Natural Disasters

The Fund plays an important niche role in meeting member’s post-disaster financing needs. RCF and RFI financing is disbursed rapidly and has a valuable catalytic impact.

83. IMF financing is a valuable component of the disaster risk financing tool kit for small developing states (Annex X). The Fund’s comparative advantage is fast disbursement of resources to meet urgent balance of payment and fiscal financing needs. For large-scale funding for rebuilding, development institutions take the lead.70 While Fund resources are not automatically available following disasters, financing is typically approved within three months across the Fund’s instruments and facilities. Disaster financing is available on concessional terms for PRGT-eligible members, among them a number of small islands and micro states with per capita incomes above the normal threshold for PRGT eligibility.71 Fund financing is expected to play a catalytic role in mobilizing other external financing, with early engagement in assessing the member’s post-disaster fiscal and balance of payments financing needs and its macroeconomic policy framework providing a basis for others to step in.

84. Small states are disproportionate users of disaster-related financing. Of the 49 instances of disaster-related Fund lending since 2000, small states accounted for a little over one-third, roughly double their proportion of the Fund’s membership (Annex Table 2). This reflected disproportionate use of the Fund’s emergency financing facilities and instruments (Emergency Natural Disaster Assistance facility (ENDA), ESF-RAC, and subsequently RCF and RFI), where small states accounted for 60 percent of the number of disbursements since 2000. By contrast, small states were much less likely to obtain disaster-related financing through augmentation of existing Fund arrangements. Fund support for small states covered a range of disasters, spanning storms, floods, drought, earthquakes, and tsunamis (Annex Tables 12).

85. Not all small states experiencing disasters have sought Fund financing. Of the 53 natural disasters reported by EM-DAT for small states since 2000, the Fund provided financial assistance in only 16 cases. These cases did not include two disasters with damages of more than 30 percent of GDP and 3 other disasters with damages in the range 20–30 percent of GDP.72 This likely reflects an ability to meet urgent BOP needs on favorable terms without Fund financing, a situation that will likely continue to apply in some cases in the future.

Merits of expanded program engagement

A broader pattern of program engagement with small states could help build disaster resilience.

86. Greater use of the Fund’s arrangements and Fund-supported programs would offer several advantages. Consistent with the thrust of this paper, it would support an ex ante approach to developing institutions and policies for responding to natural disasters. In particular, it would provide a structured framework for the design, implementation, and monitoring of resilience-building policies, and could help coordinate the delivery of capacity building. Program reporting on disaster preparedness could also help countries access other sources of external financing on better terms, including on a contingent basis. In this connection, program engagement could help structure collaboration between the Fund and other financing partners, including the World Bank. From the perspective of Fund financing, an arrangement can be quickly augmented in the event that a new natural disaster exacerbates balance of payments need.73

87. Program engagement should meet small states’ specific needs. The low interest in program engagement in the past likely reflects both capacity and policy considerations.74 With limited administrative capacity, small states are taxed by the resources needed for program design and implementation. At the same time, small states may perceive the Fund’s program conditionality as mismatched to their country priorities. These concerns could be addressed by ensuring that, where potential balance of payments needs relate primarily to disaster risks, policies under a Fund-supported program would be streamlined and focused squarely on building resilience.

88. A range of options for program engagement are available. Depending on balance of payments needs and the timeframe for strengthening policy frameworks, this could be through multi-year disbursing arrangements under the ECF or EFF, or through precautionary arrangements (SBA or SCF). A subset of small states would also qualify for the support through the Policy Support Instrument (PSI). Precautionary arrangements would accumulate access rights that could be exercised (and potentially augmented) in the event that a balance of payments need arises during the arrangement period, while qualification for an SCF would be presumed for an on-track PSI if a balance of payments need emerges as a result of natural disaster. The goal of program engagement would be to help countries transition to a level of preparedness and resilience for which ongoing program engagement would not be needed, with Fund financing potentially available as part of the safety net for shocks financing.

Use of the Fund’s emergency financing facilities and instruments

Access limits under the RCF and the RFI were increased in 2015, albeit with uneven implications across small states, depending on quota increases under the 14th General Review. Access remains low in relation to the largest natural disasters, where small states are most vulnerable.

89. In the July 2015 Board discussion of the financial safety net for developing countries, access limits under the RCF and RFI were increased by 50 percent. This step, taken with a broader increase in access limits under the PRGT, was designed to redress an erosion of access norms relative to GDP, trade, and gross financing needs (see IMF, 2015b). The increase in access under the RCF and RFI was seen as particularly important to support small states hit by natural disasters and other shocks. The increase in access did not, however, fully reverse the two-thirds cumulative erosion of RCF access since 2004 measured vis-à-vis standard economic metrics. Moreover, when access limits under the PRGT facilities and RFI were halved in 2016 with the doubling of Fund quotas under the 14th General Review, this was to the relative disadvantage of the majority of small states, whose quotas rose by less than 100 percent. As a result, the half of small states that received the smallest quota increases saw only a minor increase in the SDR value of access to RCF and RFI financing as a result of the 2015–2016 reforms (Figure 9).

Figure 9.
Figure 9.

Annual Access Ceilings under RCF and RFI (in SDR terms, January 2015=100)

Citation: Policy Papers 2016, 038; 10.5089/9781498345095.007.A001

Source: IMF Staff.

90. The RCF/RFI safety net is small in relation to the largest natural disasters. Severe disasters are likely to result in larger immediate balance of payments needs, and while Fund financing is typically higher in such cases, the increase is not fully in proportion to disaster costs. Thus, for smaller disasters (defined as involving costs of less than 30 percent of GDP), Fund emergency financing was equivalent to 11.6 percent of disaster impact, while the equivalent figure was 2.4 percent for larger disasters (with costs in excess of 30 percent of GDP) (see Annex Table 2). Some decline in the Fund’s relative role might be expected, to the extent that larger disasters involve larger reconstruction efforts financed by bilateral creditors, regional development banks, and commercial creditors. However, there is evidence that, for the most severe disasters, the need for Fund financing can exceed the current annual RFI financing limit and the corresponding RCF limit under the shock window (37.5 percent of quota). For example, in 2015, following hurricane damage to Dominica and cyclone damage in Vanuatu, Fund financing under the RCF and RCF/RFI blends were approved in amounts equivalent to 53.5 and 71.4 percent of current quotas.

91. Fund arrangements are not seen as a good substitute for the RCF/RFI safety net for severe disaster cases. In principle, where the RCF and RFI cannot meet immediate disaster-related BOP needs, members can request a Fund arrangement—which, as discussed above, could support resilience-building policies. However, in the immediate aftermath of a severe disaster countries find it difficult to free up policy-making resources for discussions with the Fund on medium-term policy frameworks.75 Given this, and with the prospect that disasters could become progressively more severe with climate change, greater access appears warranted for the RCF and RFI to meet the immediate balance of payments needs of members facing severe natural disasters.

92. To round-off the 2015 financial safety net reforms, consideration could be given to higher RCF/RFI access limits for countries impacted by severe disasters. Indeed, this approach was suggested by a few Directors in 2015. Reforms could be framed as outlined below. In the event of Board support, a formal proposal could be developed for Board consideration.

  • Annual access. For countries impacted by severe disasters, defined as causing damage of 30 percent of GDP or higher, the annual access limit under the RCF and RFI would be set at 60 percent of quota. In all other cases, the current annual access limit would apply (37.5 percent of quota). As at present, access would be determined on a case-by-case basis, based on balance of payments need, capacity to repay, and the catalytic role of Fund financing. The augmented access limit would apply to the full Fund membership—though, as discussed below, countries experiencing disasters of this scale tend to be smaller states.76

  • Cumulative access limits would remain unchanged at 75 percent of quota. Where countries benefit from higher RCF/RFI access under the severe disaster window, this would reduce remaining cumulative access below 37.5 percent of quota.

  • Measurement. Damages, for above purposes, would comprise the value of destruction of physical assets plus foregone output, measured relative to pre-disaster GDP projections. In measuring disaster damages, the Fund would draw on assessments by the national authorities, UNDP, World Bank, and other relevant agencies.

  • Letter of intent. For countries seeking financing within the augmented RCF or RFI window, an expectation could be established that the authorities’ letter of intent should document existing and planned practices in regard to the adoption and implementation of disaster risk reduction approaches. This documentation requirement would not slow access to Fund financing and would not establish conditionality. However, it would allow the Board to assess the adequacy of policy efforts to manage disaster risks, including the potential need for capacity building support for such efforts in the post-disaster period. Moreover, consistent with current policy, higher access under the RCF shocks window would only be expected in cases where the member’s existing and prospective policies are sufficiently strong to address the shock.

93. Eligibility for the augmented access window for severe disasters would be relatively rare. Historically, fewer than one-in-ten disasters in small states resulted in damages of 30 percent of GDP or higher, a ratio that falls below one-in-one hundred for larger states (Text Figure 1). Over the period 2000–2015, eleven countries would have met the proposed threshold (Table 6).77 Of this group, ten were PRGT eligible, nine were small states, and nine sought Fund financing, generally through the Fund’s emergency facilities and instruments.

Table 6.

Countries Experiencing Severe Natural Disasters, 2000—15

article image
Source: Damage estimates from EM-DAT, IMF staff reports, and World Bank PDNAs.

The “B” signifies countries presumed to blend RCF and RFI access.

94. An augmented access limit for the RCF and RFI would result in only modest additional demand for Fund resources. On the assumption that the augmented access limit is used, on average, roughly once each year, and given the typical size of countries that may prove eligible, the additional demand on PRGT and GRA resources is projected to be limited.78 Importantly, the proposed reform would preserve the financial sustainability of the PRGT.79

95. The narrowly-targeted nature of the reform would limit moral hazard considerations. While the additional Fund access would provide important balance of payments support, at the margin, for the most severe disasters, it would be available only rarely. Further, Fund financing would remain small in relation to total damages. As a result, members would retain strong incentives to develop other contingent financing arrangements and to adopt policies that foster risk reduction. The expectation that such policies would be discussed in the authorities’ letter of intent would help identify cases where preparedness falls short. This could help inform discussions on a possible successor arrangement in support of resilience building.

96. The reform would not encourage facilities shopping. Countries typically seek standalone shocks financing under the RCF/RFI, rather than requesting Fund arrangements (either on a stand-alone or parallel basis). As such, the proposal for augmented access would have no material impact on facilities shopping.80 The unchanged cumulative access limit for the RCF and RFI would maintain incentives for countries to shift toward financing under Fund arrangements in the event of repeated large disasters.

97. The impact of Fund financing will inevitably depend on a very large catalytic role. Even with scope for higher access under the RCF and RFI, the proportion of disaster costs to be met from other financing sources would remain very large.81 The Fund would continue to play an important catalytic role in identifying balance of payments needs, providing quick-disbursing funds for immediate needs, and confirming a sound macroeconomic framework for disaster relief and recovery. In the case of severe disasters, the ability of members to access a rarely-used higher access window could send a strong message of the Fund’s support, helping trigger comparable exceptional support from other development partners, which will likely involve large scale grants to maintain sustainable debt positions.

B. Role of the Fund in Climate Change Financing

The Fund’s role in helping countries develop policies for climate change mitigation and adaptation suggests that tailored assessments of progress in these areas could help countries access global climate funding.

98. The Fund could support global efforts to combat climate change by assessing and advising on countries’ macroeconomic policies as they relate to climate change preparedness. These assessments could be conducted in collaboration with the World Bank, with the Fund covering macroeconomic policy goals and implementation in its areas of competence. The latter include the adoption of energy taxes and subsidy reforms that appropriately price carbon emissions; the quality of frameworks for managing public infrastructure investments, including in climate change mitigation and adaptation; the strength of public finance management systems and their capacity to effectively intermediate budget resources dedicated to climate change programs; and the consistency of climate change spending programs with goals for fiscal and debt sustainability and macroeconomic absorption capacities.

99. Climate change policy advice could help countries develop coherent macro policy frameworks. Under the UN Framework Convention on Climate Change, countries have communicated Intended Nationally Determined Contributions (INDCs), specifying steps to be taken in the context of their own national circumstances, capabilities and priorities to help reduce global greenhouse gas emissions. Over the period through 2020, these INDCs will be formalized as national climate change programs which, in turn, should be aligned with overall national development strategies. To support this process, the Fund can advise countries on how to create sustainable fiscal space for climate change programs, PFM and investment management tools, and good international practices as regards energy taxation and carbon pricing. Fund engagement would be particularly important where domestic policy capacity is limited—for example in small states and fragile states.

100. Assessments could also help catalyze climate change financing. Official bilateral and multilateral agencies have a strong interest in providing climate change financing to countries maintaining sound macroeconomic policy frameworks. In principle, a favorable Bank-Fund assessment of a country’s climate change policy framework could simplify the process of qualifying for financing.82 Staff have discussed the climate change financing process with the Green Climate Fund (GCF), World Bank, and UN agencies. These exchanges suggested that IMF macroeconomic policy assessments would be welcome, though further work would be needed to establish the specific role that Fund assessments could play in catalyzing financing. Given the current climate change financing architecture with fragmented responsibilities across multiple funds and agencies, the Fund’s assessments would likely remain one of many factors determining funding decisions.

101. Climate change policy assessments would have resource implications which would be funded through prioritization of existing resources. Article IV surveillance would normally cover macroeconomic policies relating to climate change where these are macro-critical, but coverage would not typically be comprehensive across the areas identified above. A full assessment would typically require additional Fund resources, either to complement the Article IV consultation process or to staff a separate staff visit. This would involve additional effort of the country teams and drawing on technical assistance expertise, the sum of which would depend on the number and type of countries covered by the assessments. Given the Fund’s budget ceiling, this would require prioritization of the work of the country teams and within the overall technical assistance resource envelope.

102. Consideration could be given to IMF climate change policy assessments on a pilot basis. Small and fragile states would be priorities for Fund engagement, given their more limited administrative depth. Given potential resource costs and the as yet uncertain catalytic impact of such assessments, a pilot approach would provide implementation lessons that could adapted more widely, depending on the Fund’s evolving role in supporting members as they confront the macroeconomic challenges of climate change. A future review of the Fund’s role in supporting climate change, including through such pilots, would be useful to help refine and guide policies.

Issues for Discussion

103. Directors may wish to discuss the following issues:

  • Policy approaches. Do Directors agree that strengthened domestic policy frameworks should play an important role in mitigating disaster vulnerabilities, and that a greater emphasis is needed on developing ex ante disaster risk management frameworks and integrating the macroeconomic elements into core public fiscal, debt, and financial management practices?

  • Financing for natural disasters. Do Directors agree that small states should seek to develop more ex ante financing arrangements, including insurance and other options for risk transfer? Do Directors see scope for the international community to better support small states by developing contingent financing arrangements and supporting regional insurance pooling arrangements?

  • Climate change financing. Do Directors agree that enhanced access to financing for climate change adjustment is a priority for small states? Do Directors agree on the importance of developing less complex and administratively cumbersome application procedures to enhance financing access for small states?

  • IMF arrangements. Do Directors agree that use of Fund arrangements by small states could help in developing policies and institutions necessary for resilience to natural disasters? Where natural disasters are the main factor giving rise to potential balance of payments need, do Directors agree that program design could be streamlined and focused on resilience building policies?

  • RCF and RFI financing. Do Directors see merit in an increase in the annual access limits under the RCF and RFI to better meet the needs of members facing urgent balance of payments needs following severe natural disasters?

  • IMF climate change assessments. Do Directors see value in IMF assessments of macroeconomic policies related to climate change mitigation and adaptation? Do they favor exploring such assessments, on a pilot basis, for small states in partnership with the World Bank?

  • Capacity building. Do Directors agree that, with strained administrative capacity in small states, sustained Fund support will be critical across the full range of its activities, with a particular emphasis on capacity building?

Small States Resilience to Natural Disasters and Climate Change - Role for the IMF
Author: International Monetary Fund