The Caribbean and Pacific islands: Climate change leading to rapidly increasing risks in the most vulnerable countries

The Caribbean and Pacific islands: major victims of climate change

Climate change, translated into a continued global rise in temperatures due to human activities, is happening, and at an accelerated pace. In the coming years and decades, the severity and the frequency of extreme weather events, from hurricanes and cyclones to severe droughts and floods, are expected to increase. This is especially the case for the Pacific and Caribbean islands situated in the hurricane belt, which are considered the world’s most vulnerable states to climate change. Climate scientists expect hurricanes like Irma and Maria in 2017 and Dorian in 2019 (the fiercest hurricanes ever recorded, which pummelled the Caribbean) to become more common. As a result, the impact of natural disasters on small islands will be exacerbated.

Small Caribbean and Pacific countries are disproportionately affected by natural disasters (hurricanes or cyclones). According to the IMF, the average estimated disaster damage as a ratio to GDP is 4.5 times greater for small states than for larger ones. The main reason is that small states have fewer resources to cope with the aftermath of such natural disasters. On top of that, on small islands, the majority of the population and economic activity tends to be clustered close to the coastline, which is more vulnerable to floods. Hence, a natural disaster such as a hurricane strike can easily translate into a deep macro-economic and fiscal crisis, with an increasing frequency of extreme natural disasters meaning that those small island countries have less time and financing to recover and rebuild buffers between natural disasters.

Impacts of natural disasters on country risks

The probability of a hurricane or cyclone strike is high in the Caribbean and the Pacific Ocean, where it can negatively impact a country’s transfer and non-payment risk. The economic and financial impact of extreme natural disasters can be felt through multiple channels. The first obvious impact is on real GDP growth and nominal GDP, because of lower productivity due to damaged physical infrastructures, depressed tourism activity and weaker agriculture output, two traditionally key sectors for islands. On average, about 9% of natural disasters in small countries involve damage of more than 30% of GDP – often well above 100% of GDP for smaller islands – which makes the ex post recovery challenging and longer, and eventually reduces the growth potential.

Public finances are also very much impacted by the resulting high economic recovery spending and unanticipated needs for immediate social protection. Therefore, natural disasters widen fiscal imbalances and swell public debt. This happens even when governments are insured against hurricanes (e.g. high coverage under the Caribbean Catastrophe Risk Insurance Facility). In some cases, it translates into public debt default and renegotiation, as with Grenada – a country characterised by high public debt – after it was hit by hurricane Ivan in 2004.

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

At the level of the current account balance, small islands tend to deteriorate as a result of reduced export capacity, tourism and agriculture receipts, while imports rise (notably agriculture and capital goods) if buoyed by reconstruction programmes. The negative impact on the current account balance tends to span across years and could persist especially if there is a slump in tourism because of more frequent and severe natural disasters. Capital outflows, deterred investment and a more volatile exchange rate are also potential negative consequences that could hit the balance of payments of those countries.

Experience – e.g. with Vanuatu and Tuvalu after Cyclone Pam in 2015 – shows that rapid external debt accumulation is not uncommon in countries experiencing a series of natural disasters. This may reflect a weak underlying fiscal stance, with disaster-related borrowing exacerbating already weak debt dynamics. In the Eastern Caribbean Currency Union, the external debt-to-GDP ratio rises by almost 5 percentage points on average the year a storm strikes. However, a jump in external debt might be more pronounced in the case of a large hurricane. Here as well, the higher external debt is unlikely to decline again in the years that follow.

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

The impact is not just limited to macro-economic indicators. A major natural disaster can also affect the political environment if the population is not satisfied with the pace of reconstruction or blames inefficiency or a lack of pre-emptive action on the part of the government. Social stability can also be affected by protests and unrest, rising unemployment and poverty in the aftermath of a natural disaster.

Small islands have very limited buffers

It is worth pointing out that several factors can mitigate those negative impacts. The size of an economy is the main mitigating factor. When a storm strikes a small country, it generally affects a large section of its territory and population, while the impact in larger countries can be contained to relatively smaller areas. This also explains why small Pacific and Caribbean islands are so vulnerable to extreme natural disasters. Resilient infrastructures are of paramount importance as well. Currently, no small island can rely on resilient infrastructures to protect them against the bigger natural disasters expected in the coming decades. Another buffer lies in strong foreign exchange reserves as they smooth the impact of a hurricane or cyclone strike, act as a buffer against capital outflows and decrease the need for external lending. Moreover, financial protection reduces the impact of recovery and reconstruction costs on public finances. At a multilateral level, for example, technical and financial support from the World Bank and the IMF is available to small countries experiencing natural disasters. In the Caribbean, the Caribbean Catastrophe Risk Insurance Facility (CCRIF), which has 17 members and was set up in 2007, was the world’s first regional risk-pooling financial institution offering insurance against the most prevalent natural disasters in the region. Disbursements do not cover all the losses but offer significant support to insured countries. Nevertheless, the Caribbean and Pacific islands currently invest little in ex ante resilience-building (i.e. before a natural disaster hits) and rely heavily on post-storm recovery efforts due to high costs. Moreover, insurance will not completely mitigate the impact of a natural disaster.

Credendo’s MLT political risk ratings affected

Through the various channels of contagion mentioned previously, climate change and the associated more severe and frequent natural disasters are integrated into Credendo’s country risk assessment. They bring the most vulnerable countries into higher MLT political risk categories, as is the case for the Caribbean and Pacific islands. During a recent update, Credendo’s ratings for some of the small Pacific islands – namely the Solomon Islands, Tonga and Vanuatu – were downgraded to category 6/7.

Looking ahead, although the impact on the small Caribbean and Pacific islands remains by far the greatest, the accelerating climate change can be expected to increase risks in developing countries in the future, especially in Africa, Asia and Latin America.

Analysts: Jolyn Debuysscher – j.debuysscher@credendo.com
Raphaël Cecchi – r.cecchi@credendo.com