Donor aid and development lending for natural disasters

Donor aid and development lending for natural disasters

A good measure of the capability of individual countries to cope with a natural disaster is the ratio of the economic damages caused by natural disasters to the GDP and the countries’ fiscal resources (e.g. annual budgets), which are typically less than 50% of GDP.

In Table 1 some examples are given for countries in the Caribbean after the 2004 hurricane season. From these data it becomes clear that the economic damages caused to some countries by the hurricanes have been so severe that they could not recover without help from the international community.

As the frequency and scope of losses due to major natural catastrophes, especially tropical storms, is likely to be on the rise in the future, this example highlights the necessity for adaptation measures, including mitigation, and ex-ante risk financing solutions, including insurance, to enable these small disaster-prone nations to successfully recover from such devastating events.

Number of events

The total economic losses caused by weather-related disasters show a similar upward trend. One can see a visible increase in economic losses caused by natural disasters, with the losses almost doubling for both ‘high-income’ and ‘low/medium-income’ groups of countries over the last 20 years. Due to the considerably higher concentration of values per area and a larger number of events, the high-income countries have experienced the highest absolute increases in economic losses from natural disasters – from about US$20 billion in the early 1980s to around US$70 billion in the early 2000s.

The absolute increase in economic losses for poorer countries looks more modest – from US$10 billion in the early 1980s to about US$15 billion in the early 2000s. However, if expressed as a percentage of GDP, economic losses caused by weather-related disasters for developing countries have been much more pronounced than those in industrialized countries. Between 1985 and 1999 alone, due to the considerably higher vulnerability of their economies to natural disasters, they lost 13.4% of their combined GDP versus only 2.5% in industrialized nations (Freeman and Scott, 2005).

As can be expected from the higher number of events and larger values at risk, the ‘highincome’ countries with GDP >US$9,385 experienced the largest intertemporal variation in economic losses. However, a high degree of variation in annual economic losses can also be seen among the ‘middle/low income’ class countries (GDP <US$9,385), pointing to the inadequacy of budgetbased approaches to funding the highly variable disaster relief and reconstruction costs that prevail in developing countries (Gurenko and Lester, 2003). The growing volatility of economic losses experienced by all countries in the aftermath of natural disasters clearly demonstrates the rationale for risk financing instruments, such as insurance, that can smooth out this variability of outcomes for a fixed insurance premium.

Up until now, most Caribbean countries have been relying on external concessional borrowings from international development banks (such as the World Bank, IDB and the IMF) and international donor aid to deal with the devastating consequences of natural disasters. In fact, reliance on these two sources of funding has been a major reason for the lack of insurance solutions for small-island States. However, there is clear evidence that over-reliance on these traditional post-disaster funding models may no longer be sustainable.

The increasing frequency and severity of natural disasters worldwide makes it more and more difficult for disaster-prone nations, particularly smaller sized economies, to finance economic losses in the aftermath of natural disasters out of recurrent or even future government budget revenues, due to the limited tax base and considerable indebtedness of many of these nations. As shown in Table 2, the level of indebtedness of small-island States in the Caribbean is about four times of that for middle-income countries, which means that the room for further borrowings to finance economic recovery efforts in the aftermath of future natural disasters is severely constrained.

Donor aid has been yet another major source of risk financing for most disaster-prone developing countries. Over-reliance on this source of funding, however, has major limitations. First, by its Table 2. Indebtedness of selected CARICOM States

very definition, donor aid is not a contractual obligation of donor governments and hence its delivery is subject to considerable political uncertainty. There is evidence that donor aid is more likely to be forthcoming in cases of highly catastrophic and internationally publicized events than in cases of more frequent but less devastating events, leaving considerable post-disaster funding gaps (Freeman et al., 2003).

In addition, as the amount of overall donor aid remains rather stable over time as a percentage of donor countries’ GDP, which has been increasing in the order of 2–3% in the last decade, while economic losses caused by natural disasters have grown at a much more rapid pace, the ability of international donors to provide sufficient post-disaster financial assistance to disaster-prone nations in the future without reducing their financial commitment to other critical areas of economic development becomes a major problem.

As can be seen from Table 3, if in 1987–1989 the overall emergency and distress relief assistance accounted for only 1.6% of total donor assistance to developing countries, in 2003, it was 8.5% of total, or $5.87 billion. However, only about one-third of this assistance was earmarked for natural disasters, while the rest was used for complex emergencies (IMF, 2003). Taking this into account, the share of natural disaster aid in overall donor aid would account for only 1.3% and 4.3% in 1987–1989 and 2001, respectively. When expressed as a percentage of overall economic losses sustained by the developing countries, the donor assistance accounted for about 1% in 1987– 1989 and about 9.6% in 2003. While illustrating the growing role of donor funding in financing economic losses caused by natural disasters in developing countries, these statistics mainly underscore the fact that donor funding is clearly insufficient to meet the growing disaster risk financing needs of developing economies. Given that insurance penetration in developing countries has been almost non-existent, most of the economic losses from natural disasters had to be

we provide annual estimates of the amount of economic loss from all natural disasters, including earthquakes and climate-related events, which had to be absorbed by developing countries over the last 17 years. We calculate it as an amount of overall economic loss caused by natural disasters less the donor assistance and insurance. For the sake of simplicity, we do not take into consideration emergency reconstruction loans provided by international development banks, as most of those would have to be eventually repaid and hence should be counted as a form of risk retention.

During 1987–1989, developing countries absorbed on average around 93% of total economic loss from natural disasters or about US$31 billion per year. If, in 1987–1989, developing countries retained on average around 95% of total economic loss from natural disasters or about US$23.3 billion, in 2003 their annual loss retention has decreased down to about 90% or over US$18.3 billion, mainly due to the increased share of donor funding allocated for natural disasters. Also, as can be seen from Table 4, the overall amount of losses from natural disasters absorbed by the developing countries is not only large but also highly variable, as measured by the coefficient of variation, which in this case is 50%.1 Such loss volatility further exacerbates the level of social and economic disruptions caused by catastrophic events and points to the importance of insurance solutions. With the frequency and severity of natural disasters on the rise, it is obvious from these statistics that the existing model of financing natural disasters in developing countries is unlikely to be sustainable in the long run, due to the increasing volatility of global climate and the growing resource gap between the overall economic damages sustained by developing countries and the available financial assistance from the donors and commercial insurers to finance them.

A part of the above mentioned funding gap caused by natural disasters can be covered by concessional lending from development banks, such as the World Bank, Inter-American Development Bank, and Asian Development Bank. In fact, loans for disaster reconstruction purposes have become an important part of their lending portfolios. As can be seen in Figure 8, since the early 1980s the World Bank’s lending for disaster reconstruction purposes has been on the rise, with much of this lending being quite recent. All in all, during this period the World Bank has originated 528 loans that, in one way or another, addressed the risk of natural disasters. Yet, similar

to the donor aid, most of this lending has been provided in the aftermath of natural disasters and carried few incentives for countries to engage in proactive risk management. In addition, despite the growing percentage of the Bank’s lending allocated to natural disasters, the amount of reconstruction lending has been small relative to overall economic losses – on average about 2% of economic loss retained by developing countries. Another important drawback of reconstruction loans is that it typically takes up to 1 year for them to disburse, which leaves governments scrambling for liquidity in the first few months after a disaster.

Last but not least, the existing ex-post, ad-hoc model of financing natural disasters losses in developing countries that has been widely adopted by the international donor community and development lenders fails to provide disaster-prone countries with sufficient incentives for mitigation and risk reduction. As donor funding arrives in the aftermath of major catastrophic events, and by and large is used for emergency relief and reconstruction purposes, very little of this aid is invested in mitigation projects to reduce losses from similar catastrophe events in the future. As opposed to commercial property insurers, which frequently link the very availability of insurance coverage to the implementation of concrete risk reduction measures by the insured, donors require nothing of that sort from disaster-prone countries. As a result, countries at risk see little economic or political benefit from investing in mitigation or better enforcement of construction codes or land-use policies that would restrict construction activities in harm’s way. The unfortunate outcome of these disaster funding policies can be seen clearly in Figure 9.

Despite the overall focus of this article on the economic implications of weather-related hazards, we thought the example of seismic vulnerability of structures in developing countries would provide a useful illustration of the matter at hand. Figure 9 depicts aggregate seismic composite vulnerability curves for residential and commercial structures in developing (LD) and highly developed (HD) economies. Vulnerability is measured in terms of the mean damage factor, which is the ratio of the cost of repair to the total insured value. Vulnerability functions are defined in terms of the type of the structural system (for example, frame or walls), the method and time of construction, and the construction material. Typically, they are developed on the basis of an analysis of claims data from catastrophe events throughout the world, engineering-based analytical studies, expert opinion and laboratory tests.

For instance, an earthquake of intensity 9 would cause a mean damage of 23% for residential and 15% for commercial buildings in developing countries, while the same event would cause a mean damage of less than 7% for commercial and 4% for residential structures, respectively, in highly developed countries. These statistics demonstrate the urgency of developing more effective risk financing policies by the donor community that can encourage developing countries to invest in reducing their vulnerability to natural disasters in the future. By reducing the physical vulnerability of structures to natural hazards and investing in risk mitigation projects, developing countries will not only save billions of dollars in future economic losses but, more importantly, save thousands of lives.

4. Conclusions

The number of weather-related disasters and the economic losses caused by them have been rising during the last decades and will continue to do so in the future due to climate change. Although the economic losses caused by natural disasters are the highest in industrialized countries, in relative terms their overall impact on these economies has been rather minimal, as they still have sufficient financial and technological resources to absorb it. However, for many of the poorer countries, the increasing exposure to natural catastrophes in conjunction with the higher vulnerability of their economies to natural disasters and highly volatile and insufficient external financial assistance entails large risks for their economic and social development. In the absence of new innovative global catastrophe risk financing mechanisms, including catastrophe insurance, that can address the increasing volatility and severity of losses sustained by these economies due to natural disasters, and, at the same time, provide appropriate incentives for ex-ante risk management for disaster-prone countries and their populations, the adverse impact of the global climate change is likely to become even more pronounced in the future.