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Sep 12, 2017

Fact sheet: the economic impacts of natural disasters in Latin America and the Caribbean

Do country GDP growth rates suffer any long-term consequences from disasters?

· Most countries do eventually bounce back. There are very rare cases, such as the 1978 earthquakes in Iran or the December 1972 earthquake in Nicaragua that afflicted nations with negative growth for ten years after the event. But these events were followed by radical political revolutions that fundamentally changed their economic and political systems. This is not likely to be the case with the storms currently affecting the Caribbean basin and the United States. Still, we are in a new world with climate change, and it is difficult to predict how costly the human, physical, and economic toll will be from future severe weather events.

How vulnerable is Latin America and the Caribbean to natural disasters?

· The region is vulnerable to earthquakes, hurricanes and storms. A report compiled by the United Nations, taking into account exposure to natural events and a society’s response, found four nations of the region (Guatemala, Costa Rica, El Salvador, and Nicaragua) to be among the world’s 15 nations most at risk from natural disasters.

· Fortunately, catastrophic disasters are rare. Even for countries most vulnerable to hurricanes, storms and floods face only a 2-5% chance of a catastrophe in any given year where output falls by 4 percent and fails to recover.

· But such events are so devastating they can affect a nation’s economy the way a severe head injury affects the brain. Injury quickly spreads in a chain reaction from the place of impact to distant regions; critical functions are disrupted; activities are shut down. A severe natural disaster can wipe out agriculture and industry. There is a need to spend for humanitarian relief and for rebuilding. And with much of its revenue base destroyed and basic activities like tax collection hobbled, the government limps along with little ability to help the nation bounce back.

How vulnerable are small countries to natural disasters?

· Small countries are at disadvantage when struggling with post-disaster relief. Sri Lanka, for example, has more difficulty dealing with the aftereffects of a cyclone than India, because it is unable to readily mobilize resources from distant and unaffected areas, or resettle displaced people.

· Smaller developing countries also tend to have less diversified economies. They usually don’t have sectors that can take up the slack and even expand to make up for others that have been hard hit or wiped out. That is especially true for agriculturally-dependent countries, that have few options when coffee, cocoa and other plantations are uprooted.

What can a small country do to make itself less vulnerable to natural disasters?

· All countries, but particularly small ones, need to do two things to better cope with natural disasters: save more and improve its governance.

· Increasing savingsmeans more resources for investments and a greater ability to recover from natural disasters.

· Take the February 2010 earthquake in Chile. It measured 8.8 on the Richter scale and was followed by a tsunami. More than 500 people were killed, more than 1 million displaced, and economic losses soared to US$30 billion, or almost 19% of GDP. Chile’s tradition of sound macroeconomic management allowed it to increase its saving rate by 11 percentage points between 1985-2012 compared to 1960-1984 and gave it the “fiscal space” to rebuild and get back on its feet without relying on foreign aid.

· Chile is also a good example of good governance, scoring well on rule of law indicators and planning for the future. The country has laws in place that establish strict building codes and made building owners liable for losses resulting from poor construction. It has a strong network of decentralized emergency personnel that can be mobilized without awaiting instructions from the capital, which could be cut off in a natural disaster.

How important is international aid when a country suffers a natural disaster?

· International assistance is helpful but limited. In an examination of 98 cases of natural catastrophes between January 1970 and June 2008, there was a median increase in Official Development Assistance to stricken countries of 18% compared to the previous two years. That amounted to only 0.25% of those countries’ GDP and 3% of estimated economic damages. Moreover, some of that aid had already been granted; it was simply reallocated to humanitarian assistance from other sectors where it had been assigned before.

I can insure my car or my house, or my person. Can countries do the same thing?

· A country can get insurance but a study showed few governments do so, in part because they perceive the costs as to high for the benefits obtained from the policies.

· One of the most promising forms of disaster insurance is known as a catastrophe (or cat) bond, a tradable financial instrument that spreads risk across global capital markets. These bonds are usually issued by governments or reinsurance companies—the insurers of the insurers—and backed by U.S. treasury bills. Though they typically pay out a small fraction of the damages, they can provide important benefits in the case of the worst catastrophes.

· Cat bonds provide a key advantage. Since payouts are based on the severity of the event, rather than estimates of damages, they can be made quickly and with little contention, allowing governments to provide emergency relief before foreign aid arrives.

· Countries at high risk of a natural disaster are also more in danger of defaulting on their debt if a catastrophe strikes. That means they have less credibility on capital markets and must sell their debt at lower prices, with higher yields. By reducing the risk of default on non-contingent debt, which must be repaid even after a natural disaster, cat bonds can reverse that equation. In the baseline calibration of the model, we show that cat bonds can enable governments to increase their external borrowing from around 30% to more than 60% of GDP, providing welfare gains equivalent to several percentage points of consumption.

· In 2006, Mexico became a pioneer in Latin America by issuing a US$160 million cat bond to cover damages in the event of an earthquake. But for most countries, insuring against catastrophes is exceedingly expensive. Cat bonds cost up to four times or more what the typical country is willing to pay to reap the welfare gains. This is largely because of the immensely complex challenge of calculating a once-in-a-century event and related costs. A car insurance company can use data from thousands of accidents to calculate with a good degree of precision the risk of a collision in which a bumper needs to be replaced. But no company can yet predict with precision the probability of an exceedingly rare but devastating earthquake that kills thousands of people and leaves billions of dollars in damages. Moreover, no private company is likely to invest in the costly risk analysis and modeling required to find out: their work would simply end up in the public domain. The result is an information-starved environment and coverage is expensive. But here the public sector could play a critical role. Governments and multilateral institutions could subsidize the necessary research and help grow the market.

About the IDB

The Inter-American Development Bank is devoted to improving lives. Established in 1959, the IDB is a leading source of long-term financing for economic, social and institutional development in Latin America and the Caribbean. The IDB also conducts cutting-edge research and provides policy advice, technical assistance and training to public and private sector clients throughout the region.

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