How to Manage the Fiscal Costs of Natural Disasters

Abstract

Natural disasters often entail considerable physical and economic costs, with attendant adverse implica- tions for external and fiscal balances owing to postdis- aster relief and recovery efforts (IMF 2003; Rasmussen 2004; Barro 2006; Raddatz 2007; Hochrainer 2009; Noy 2009; Acevedo 2014; Banholzer, Kossin, and Donner 2014; Cabezon and others 2015; IMF 2016a; Marto, Papageorgiou, and Klyuev 2017; Berlemann and Wenzel 2018).1 The increasing frequency and severity of natural hazards and extreme weather events have raised the economic costs associated with these events. Between 1950 and 2015, 40 countries were hit by natural disasters that caused damage in excess of 10 percent of GDP (Figure 1). Among small island states, 1 in 10 natural disasters involves economic damage costing more than 30 percent of GDP (IMF 2016b).2 Although the probability of being hit by a natural disaster does not differ systematically between advanced and developing economies (Sawada and Takasaki 2017), low-income countries tend to suffer disproportionately large and lasting damage rela- tive to their economic sizes and populations (Rent- schler 2013). This how-to note focuses on the management of the fiscal costs associated with natural disaster risks. Unlike other types of fiscal risks (for example, unex- pected macroeconomic changes or materialization of contingent liabilities), a natural disaster presents a unique challenge to fiscal risk management and budget processes because of its exogenous nature and potentially overwhelming scale. This note discusses how governments can build fiscal resilience against natural hazards and strengthen fiscal management after a disaster, including through budgeting frameworks and other fiscal policies. The note aims to answer three central questions: How large should fiscal buffers be? How should fiscal buffers be built up? How should fiscal buffers be used efficiently and transparently once a natural disaster has struck? These three questions directly relate to fiscal policy, fiscal risk manage- ment, and the budget process—all core areas of IMF expertise. To address them, the note focuses on fiscal strategies for financing recovery efforts and considers approaches to mitigate disaster impact. The note also provides guidance on how to conduct regular risk anal- yses of natural disasters’ potential fiscal consequences and outlines best practices for defining and accounting for the contingent liabilities associated with natural disasters in budgeting frameworks. Finally, the note touches on approaches for risk reduction, disaster risk financing strategies, and risk transfer mechanisms, such as various insurance instruments. One central concern is how large the fiscal buffers against such contingencies should be. Natural disasters can worsen a government’s fiscal position—directly and indirectly—by eroding the revenue base and increas- ing expenditures. They often undermine economic growth and set back development objectives, such as poverty reduction, especially in developing and low-income countries with significant infrastructure gaps and institutional constraints. Building resilience against catastrophic events may lower these fiscal risks...