The economic impact of droughts is less visible in the short term but the long-term effects should not be overlooked

Climate change is affecting countries mainly through intensifying natural disasters, potentially causing significant human, economic and social costs. The Pacific and Caribbean islands are clearly the most vulnerable due to their exposure to rising sea levels, the regularity of severe hurricane and cyclone strikes and their small size. Indeed, in larger countries, damage from natural disasters is often more localised and therefore represents a relatively small share of the economy. That being said, larger countries are not spared the negative fallout from climate change. More and more countries – especially in Latin America, Australasia and Sub-Saharan Africa – are regularly being hit by droughts, which are increasing in both frequency and ferocity due to global warming. Compared to severe earthquakes, hurricanes and cyclones, the impact of these droughts on macroeconomies might seem less visible and more hidden, especially in the short term. However, the economic effects in the long term should not be underestimated.

Droughts often don’t destroy physical assets directly, which blurs their economic impact

Natural disasters can lower productivity through damaged physical infrastructure, destroyed harvests or a temporary halt in production. Consequently, real GDP growth tends to be significantly lower the year a country is hit by a major natural disaster than the average real GDP growth witnessed in the years before the disaster (see graph 1 for some illustrative examples). When comparing the different effects of natural disasters on real GDP growth, severe earthquakes, hurricanes and cyclones seem to have the largest impact in the year the natural disaster strikes (year ‘t’), especially on small islands. Droughts ‘merely’ shave off a few percentage points of real GDP growth in year ‘t’ compared to the 5-year historic average. The main reason – besides the size of the country and the scope of the natural disaster – is that severe earthquakes, hurricanes and cyclones have a major direct impact (e.g. by destroying physical assets) and more often affect all sectors in a country. Droughts tend to have a smaller and more gradual cost, which is more spread out over time. Furthermore, droughts harm the agriculture sector the most, followed by the manufacturing sectors depending on hydroelectricity or agriculture input (more prevalent in Sub-Saharan Africa and Latin America), while other sectors are less directly impacted. This highlights the importance of the structure and diversification of an economy. That being said, droughts tend to be more frequent and their frequency and severity is likely to increase over time against the backdrop of global climate change. Hence, economic growth is being reduced more regularly in countries often hit by droughts, affecting real GDP growth in the long term. Furthermore, physical capital is often not directly damaged in the case of droughts (unless they are accompanied by wildfires). Nonetheless, the destruction may occur over the longer term, such as land degradation, building damage due to soil subsidence, long-term effects on perennial crops and livestock production, etc. Through this channel, long-term economic growth suffers as well. In addition, repeated drought can also increase migration, causing social pressure (in the case of domestic migration) and depriving countries of their labour force in the long term (in the case of migration abroad). Lastly, severe droughts tend to be followed by devastating floods. In general, floods destroy physical assets directly and decrease economic growth. Therefore, droughts can shrink economic growth indirectly in this way.

Note that ‘t’ is the year the natural disaster struck.

Impact of natural disasters on public finances

Natural disasters can harm public finances too even if the impact is not always straightforward given the multiple factors at play. Government spending usually increases after a major natural disaster in order to rebuild the country or region or provide aid while tax revenues decline. Publicly owned enterprises experiencing disaster-related losses can add to the burden as well. That being said, the impact of droughts may be less visible on public debt than in the case of severe earthquakes, hurricanes and cyclones (illustrative examples shown in graph 2). In many cases, a sharp rise in public debt has not been observed following a severe drought. There are multiple reasons to explain this. First of all, the type and scope of the natural disaster is important as well as the structure of the economy. In the case of droughts, these natural disasters have a lower but more recurrent cost, which translates to a more gradual rise in public debt. Secondly, in general, developing countries are typically less diversified, leaving them dependent on a relatively small number of sectors. Many of them are heavily dependent on commodities such as agriculture, metals, oil and gas. As public revenues depend largely on these commodities as well, fluctuations in commodity prices will affect public finances more deeply. Thirdly, natural disasters can change government priorities and divert resources from more productive public investments such as improving education or health care. Although the short-term impact on public debt will be less profound in this case, these shifts in priorities will hurt public finances in the long term. Additionally, in order to avoid a heavier public debt burden and as such a higher debt service, the government might be tempted to monetise the fiscal deficits, stirring further inflation (which is likely to be already under pressure amid rising agricultural prices). Lastly, in practice, election-related spending, fiscal consolidation (sometimes required under an IMF programme) and political instability tend to be of great influence.

Please note that ‘t’ is the year a natural disaster struck. For countries where year ‘t+3’ comes after 2019, the impact of the covid-19 pandemic is not included in the figures. 

Impact on external macroeconomic indicators dependent on economic and financing structure

Natural disasters are capable of wrecking the current account balance as they may reduce export capacity and imports tend to rise (notably agriculture and capital goods). While the impact on external balances depends on the severity, type and scope of the natural disaster, the economic structure of the country is of paramount importance. Southern Africa experienced the most severe droughts in 80 years during 2015 and 2016. The drought was prolonged and widespread across the region. This had a clear negative effect on economic activity, as the agriculture sector is an economic and job driver in the region. A comparison between the impact of drought on Malawi and South Africa illustrates the importance of economic structure and a number of other factors that can have an influence on macroeconomic indicators. Malawi’s external balance was clearly the hardest hit (graph 3), and the country’s current account deficit almost doubled compared to the historical average of the five previous years. In addition, the foreign exchange reserves, which increased on average by 20% year on year in the 5 years before, experienced a much slower pace of accumulation of 8% during the years of drought. Moreover, external debt vis-à-vis GDP rose more rapidly in the years of drought (with a yearly average of almost 3%) compared to the historic average (of around 1.7%). In contrast, the droughts barely influenced the evolution of the external macro-economic indicators for South Africa (graph 4). The current account deficit hardly widened while the external debt even increased less in the years of drought than in the 5 previous years. Even though foreign exchange reserves shrunk by about 5% during the droughts, this is a relatively insignificant development compared to Malawi as South Africa only experienced a mild accumulation of 3% year on year in the five preceding years on average. The main explanation can be found in the diversification and economic structure of the country. Agriculture (mainly tobacco) typically accounts for half of current account earnings for Malawi while in South Africa it accounts for less than 10% of current account receipts. Inflows of FDI, portfolio investments and aid also play an important role. These inflows are an alternative to issuing external debt and using foreign exchange reserves to finance the current account deficit, which make an economy more vulnerable to external shocks in the long term. Some countries are more robust as they easily attract portfolio inflows and FDI – even in more challenging times – thanks to perceived strong institutions and orthodox fiscal and macroeconomic policies. External aid might also be an option and easily flow in after a natural disaster, e.g. in order to avoid famine after a serious drought. However, even in this case, aid might not be entirely additional. The combination of limited donor resources and constraints on local counterpart funding (often required) may in practice replace existing development aid, at least in part. 

Credendo’s MLT political risks affected

Taking into account the various channels of contagion and mitigation, climate change and the associated more severe and frequent natural disasters have been integrated into Credendo’s country risk analysis. Droughts have a smaller, less visible and more gradual cost than severe natural disasters such as major earthquakes, cyclones and hurricanes. In addition, the interplay with different macroeconomic evolutions and different economic and financing structures as well as the size of an economy can also blur the risk assessment. Nonetheless, the economic impact of droughts in the long term can be large, especially as droughts are increasing in both frequency and severity. Looking ahead, the countries most at risk of severe drought are situated in Sub-Saharan Africa, followed by Latin America and Australasia.

Analyst: Jolyn Debuysscher – j.debuysscher@credendo.com