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How Access to Credit is vital for Economies hit by Natural Disaster

Carol Tan - 10th April 2014

Carol Tan reviews a 2013 study that investigated the difference in impact on economic growth among countries hit by disasters based on the efficiency of their credit markets.

In November 2013, Typhoon Haiyan slammed into various countries in the Pacific, the hardest hit of which was the Philippines. In the wake of the disaster, aid money flowed quickly to assist victims with relief and rebuilding — about a quarter of the estimated aid needed was raised within the first four days. But after the massive destruction and the large influxes of donations, what generally happens to a country’s economy? And what are the key variables that explain the varying impact of crises on post-disaster economic development?

A 2013 study published in Oxford Economic Papers, “Disasters and Development: Natural Disasters, Credit Constraints, and Economic Growth,” investigates the difference in impact on economic growth among countries hit by disasters based on the efficiency of their credit markets. The authors — Thomas K.J. McDermott of the London School of Economics, Frank Barry of Trinity College Dublin and Richard S.J. Tol of the University of Sussex/Vrije Universiteit — test their hypotheses over 178 countries covering the period 1979-2007 and construct a theoretical model.

The study’s findings include:

  • Natural disasters negatively impact economic growth in the same period. For example, a country with a low level of financial development such as Burkina Faso (average credit-to-GDP ratio of 13%) will reduce growth in the same period by about 1.3%. Even more financially developed countries such as the Czech Republic will witness a reduction of approximately 0.26%.
  • The extent of the impact of a natural disaster on a country’s economic development depends on the maturity of its financial markets. In countries where access to credit is difficult, output is severely impacted by the occurrence of natural disasters.
  • The effects of a natural disaster are mitigated with credit. If credit is amply available, any shock that destroys some capital stock (buildings, infrastructure, etc.) in the first period is compensated by increased investment such that the capital stock in the near future is unaffected.
  • Growth prospects of a rich country are therefore unlikely to be severely affected by the occurrence of natural disasters. This is because increased investment will compensate for losses to capital stock, returning the economy to its pre-shock long-term growth trajectory.
  • Disasters have larger direct effects on poor countries than rich countries. The credit channel in particular plays an even more important role in the impact on economic growth in poor countries. For credit-constrained economies, a disaster event cannot be fully compensated by increased investment, leaving the economy permanently worse off in output. Thus, a disaster may not only reduce the short-term output of the economy but reduce its growth rate as well.
  • The effects of disasters are persistent over time. Disasters reduce average annual growth over the medium term (five-year period). This effect is more pronounced for poor countries.
  • Better political institutions are also confirmed to mitigate disaster effects. This is in line with previous literature by Matthew E. Kahn and Ilan Noy that found weaker institutions are associated with more severe effects from disasters.

The credit channel therefore proves extremely important in the road to recovery for post-disaster nations. The study concludes: “The role of access to finance appears to be a distinct channel of effect from disasters to economic growth, and not just a proxy for related factors such as poverty, economic structure (i.e., dependence on agriculture), political institutions, government spending, or macroeconomic stability.” However, other causal mechanisms need also to be investigated. As the authors note, “an alternative channel of causation from natural disasters to economic growth, which [was] not considered explicitly in this article, is their potential effects on technological progress.” It is critical, they state, for further research to be conducted on this line of causation in order to remove the potential conflating of the credit and technological effects.

 

 

Carol Tan is currently a research assistant at the Harvard Kennedy School's Shorenstein Center on Media, Politics and Public Policy. This piece was originally published on Journalist's Resource