The burden of vulnerability on small states
Small states are particularly exposed to the financial impacts of shocks, ranging from natural disasters to the ongoing COVID-19 pandemic and man-made events such as the war in Ukraine. Shocks disproportionately and recurrently affect small states due to their particularities. They have small populations and economic bases combined with geographically concentrated economies, which makes them particularly vulnerable to shocks. They tend to be geographically isolated, making it difficult to mobilize resources to respond to shocks. Moreover, their growth trajectories tend to rely on few sectors (undiversified) or on large neighboring countries. These dynamics underscore the central importance of building financial resilience in small states when it comes to fostering development and poverty reduction.
Eswatini, a landlocked country in South Africa, reflects these challenges in Africa. Increasingly, like many other small states around the world, Eswatini is struggling to manage the impacts of cumulative shocks that are driving up inflation, draining the budget and current account, hampering GDP growth and increasing debt. and budget deficits. To make a sobering return in time (Figure 1): in 2015/16, an El Niño drought left a third of the population facing severe food insecurity, cost the government 19% of its annual expenditure (equivalent to 7% of GDP), and pushed inflation to 7, 8%. In 2018/19, drought continued to plague the Southern Africa region, particularly South Africa, resulting in tariffs in the Southern African Customs Union (SACU) on which the government of eSwatini depends (GoeS) for its revenue, forcing GoeS to incur additional debt. In 2020, the global COVID-19 pandemic hit, against which the GoeS mobilized a large response programme, estimated at $67 million, or 1.5% of its GDP. Today in 2022, as the war in Ukraine continues, Eswatini faces pressures on the current account, reserves, taxation and inflation. Each of these combined shocks drains budgetary resources and diverts civil servants’ time and attention from service delivery to crisis response. To push the poverty rate lower than where it stubbornly sits at 28%, building financial resilience must become a priority. And that’s the case.
Figure 1. Repeated impact of cumulative shocks in Eswatini
Financially Resilient Winds of Change
Emerging from the El Nino drought, the GoeS decided it was time for a change. In March 2020, the GoeS requested support from the World Bank to conduct a diagnosis of disaster risk financing. The diagnostic assessed the financial impact of shocks in Eswatini, the existing legal and regulatory structure for disaster risk management and response, and the funding approach for disaster response. The World Bank mobilized a team and mobilized resources for the disaster protection program. The timing was (unfortunately) perfect – when the diagnosis started, COVID-19 hit the Africa region and the team observed GoeS’s ability to fund shock response in real time.
The data uncovered confirmed that like other small states, Eswatini faces challenges in funding disaster response. Particularly important in Eswatini, shocks eat up (limited) fiscal space, a particularly acute problem for drought. Drought in Eswatini invariably means drought in South Africa, which experience has shown reduces SACU revenues. As SACU revenue accounts for nearly half of GoeS revenue, droughts increase expenditure and cut revenue, the ingredients for a budget crisis. This was the case in 2016 when this dynamic led the GoeS to increase debt to GDP from 13.9% in 2014 to 24.9% in 2016. Furthermore, although Eswatini’s currency is pegged to the South African rand, high inflation triggered by rising food prices Central Bank of Eswatini to raise the policy rate above the South African Reserve Bank policy rate in January 2017, increasing the vulnerability of the South African Rand. peg of the currency. The COVID-19 pandemic again led to a sharp increase in debt to 43% of GDP in 2021, from 33.9% in 2018.
Exposure to shocks due to lack of financing instruments
In addition to this acute fiscal exposure to shocks, the GoeS currently has no financing instruments in place to fund shock response and instead relies entirely on ex post fiscal reallocations and borrowing – a complete funding gap . The lack of funding capacity to respond to shocks was laid bare during the COVID-19 crisis when the GoeS had to quickly seek funding from external sources to respond. To quantify the indicative financial benefits of developing a more comprehensive risk stratification approach to financing shock response, as part of the diagnostic, the World Bank team conducted a statistical Monte Carlo simulation exercise . Two financing strategies were compared (Figure 2):
- Basic strategy. Indeed, the status quo where the GoeS would initially rely on $25m of emergency ex post budget reallocation to fund shock response, and for costlier shocks it was assumed they would rely on ex post sovereign borrowing.
- Strategy B Here, an international risk stratification strategy based on best practices has been modeled and composed of three instruments: a reserve fund, a contingency line of credit and a sovereign insurance transfer product. Under this strategy, the reserve fund would first be used to finance the response to minor shocks. For more severe shocks, the reserve fund would be depleted and the GoeS could draw on a contingent line of credit. Finally, for extreme shocks where the contingent credit line is also exhausted, payments from a sovereign insurance product would fund response efforts. This approach of combining multiple instruments is called risk stratification and has proven to be the most effective way for governments to finance the response to shocks.
The results demonstrated the significant cost savings that small states like Eswatini can derive from a risk stratification strategy: $2-6 million for frequent events (i.e. events of 1 every 5 years to 1 every 10 years) and up to $26 million for the most serious events. This analysis was of course indicative and further technical work would be required to justify the adoption of risk financing instruments. However, it provides an important data point for small states in the Africa region regarding the benefits of adopting comprehensive risk stratification financing strategies.
Figure 2. Proposed risk stratification strategy for Eswatini
Source: World Bank, 2022 – Eswatini Disaster Risk Financing Diagnostic.
Lessons for small states
So what lessons can we learn from the case of Eswatini to build resilience in small states? Immediately three come to mind. First, small states must take seriously improving their financial resilience – the compound shocks will continue to play out and without focused action in this space, small states will find themselves in a perpetual cycle of jumbled and manic responses to shocks. Second, the adoption of a national disaster risk financing strategy is essential to force the prioritization of scarce budgetary resources in response to shocks. Currently, Eswatini does not have such a strategy (although they are in the process of developing one) and so when a shock occurs, several stakeholders advocate for their sector to be prioritized for fiscal resources, which invariably means that no sector is a priority. Finally, developing robust risk stratification strategies can generate significant financial gains for small states when funding disaster response. Multiple financial instruments can ensure that the government has sufficient liquidity to mobilize a rapid response and thus avoid the fate that small states can suffer when hit by shocks (inflation, rising deficits, reduced economic growth) .