## Calibrating Fiscal Rules: A Consideration of Natural Disaster Risks

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### I. Introduction and Purpose
- Large natural disaster shocks weaken revenue mobilization, increase priority expenditures, raise borrowing, and can undermine debt sustainability.
- Incidence of natural disasters is expected to increase, requiring structural, financial, and postdisaster resilience: enhancing macro-resilience, adaptation capacity, regional insurance, external grants and financing, and fiscal buffers.
- Toolkit extensions relative to the 2018 Fiscal Affairs Department calibration toolkit:
  - allow inputs to parameterize frequency and intensity of natural disaster risks;
  - model asymmetric growth shocks reflecting natural disasters;
  - incorporate mitigating mechanisms such as regional insurance disbursements or external financing;
  - provide inputs for adaptation investment needs when countries set an expenditure or budget balance rule.
- Objective: identify a prudent medium-term fiscal anchor and an annual deficit or expenditure path to reach the anchor within a user-specified horizon.

### II. Calibrating the Medium-Term Debt Anchor (Method and Sensitivities)
- Purpose: determine a prudent fiscal buffer so debt will not exceed a specified limit over the medium term under stochastic macroeconomic shocks.
- Simulation horizon flexibility: up to a 10-year forecast horizon (2018 toolkit default was six years).
  - A longer horizon tends to imply a lower debt anchor level.
  - Simulated debt anchor can be sensitive to horizon choice if shock dispersion is large.
- Natural disaster shocks are asymmetric and can cause persistent GDP deviations from trend.
- Modeling approaches:
  - Direct specification of growth effect after a disaster (example: assumed to be −5 percent of GDP in Table 1, column B).
  - Stochastic formulation: Yt = Yt* + ∏Dt·Zt
    - Dt ~ Bernoulli(p) with p set exogenously.
    - Zt ~ Pareto with scale parameter γ and tail index a calibrated to match average marginal growth effects and skewness.
  - Two-step approach: small shocks in standard growth shocks; large shocks from Pareto distribution calibrated from historical realizations or expectations.

### Key Illustrative Numerical Results (Table 1 excerpts and text examples)
- Baseline (no natural disaster risks; typical growth shocks normal distribution) → simulated debt anchor: 42.9 percent of GDP (eight-year horizon).
- With natural disaster shocks (probability p = 10 percent; adverse effect −5 percentage points of GDP) → simulated debt anchor: 32.4 percent of GDP (eight-year horizon).
- Sensitivity examples (preserve exact figures):
  - Increasing annual probability from 10 percent to 25 percent reduces the debt anchor by around 10 percentage points of GDP (Table 1, column C2).
  - Raising negative growth effects by 3.75 percentage points of GDP reduces the debt anchor by 8.40 percentage points to 24 percent of GDP (Table 1, column C3).
  - Doubling risk tolerance from 10 percent to 20 percent raises the prudent debt anchor from 24 to 40 percent of GDP (Table 1, column C4).
- Selected parameter and outcome figures (excerpted exactly where shown):
  - Last year debt-to-GDP: 48.3 (also listed as 48.34 in table).
  - Debt limit: 60.0
  - Forecast horizon examples: 6, 8
  - Risk tolerance examples: 10.0, 20.0
  - Average historical growth rate: 3.3
  - Average historical primary balance: −1.2
  - Natural disaster occurrence in scenarios: No / Yes
  - Probability of occurrence examples: 10, 25
  - Average growth impact examples: 5, 5.8, 7.5
  - Pareto: scale parameter examples: 0.042, 0.070
  - Pareto: tail index examples: 6, 5
  - Climate fund disbursement example: 5
  - Mean growth shocks (average across simulations): 3.29, 3.25, 2.63, 2.73, 1.98, 2.34, 2.34, 2.34
  - Median growth shocks (average across simulations): 3.31, 3.26, 2.85, 2.91, 2.23, 2.86, 2.86, 2.86
  - Skewness growth shocks (average across simulations): −0.01, 0.01, −0.32, −0.22, −0.26, −0.52, −0.52, −0.52
  - Mean primary balance (average across simulations): 0.28, −0.09, −1.11, −1.19, −2.18, −2.05, −0.43, −0.48
  - Debt anchor outcomes (selected): 46.5, 42.9, 33.0, 32.4, 22.5, 24.0, 39.6, 39.9

### Trade-offs and Interpretation
- Natural disaster risks materially lower prudent debt anchors relative to baselines that omit disaster risks (example: 42.9 to 32.4 percent of GDP).
- Higher risk tolerance implies smaller safety buffers but increases exposure to debt distress and potential need for abrupt fiscal adjustments; this can have political, social, and international finance consequences.
- Policy implication: combine buffers with risk-transfer and risk-sharing instruments and plan adaptation investment within rules-based frameworks; allow temporary and gradual deviations for reconstruction.

### Incorporating Mitigating Measures (Mechanisms and Effects)
- Complementary mechanisms reduce the need for very large fiscal buffers. Examples enumerated in the text:
  - climate or natural disaster funds (Fiji, Grenada, the Philippines, Tuvalu),
  - regional insurance (Eastern Caribbean Currency Union),
  - catastrophe bonds (Barbados and Mexico),
  - African Risk Capacity,
  - Catastrophe Containment and Relief Trust (IMF),
  - Catastrophe Deferred Drawdown Option (Cat DDO) (World Bank).
- Toolkit treatment of a contingency fund:
  - User specifies size X percent of GDP for a fund.
  - If at least one disaster occurs during forecast horizon N, the fund disburses (X/N) percent of GDP annually when activated.
  - Disbursements mitigate the lower primary balance effect after disaster and reduce required debt anchors.
- Illustrative example preserved exactly:
  - With a disbursement of 5 percent of GDP from other mechanisms, simulated debt anchor would be 40 percent of GDP, relative to 24 percent of GDP in absence of insurance mechanisms (Table 1, columns C3 and D).

### Country Example — Grenada (mitigation architecture, text details)
- Contingency fund with freely available cash reserves about 2.5 percent of GDP.
- Contingent coverage up to 3.5 percent of GDP.
- Cat-DDO approval of 1.7 percent of GDP by the World Bank.
- Budgetary contingency about 2 percent of revenues each year or $15 million Eastern Caribbean dollars.
- Parametric insurance policies (Tropical Cyclones and Earthquakes and Excess Rainfall policies; Caribbean Oceans and Aquaculture Sustainability Facility).
- Negotiated debt service reduction clause in event of a natural disaster.
- National Transformation Fund’s Contingency Fund reformed in 2019 to define objectives for relief, reconstruction, and recovery; rules of accumulation; governance and accountability arrangements.
- Note: payments for risk-transfer/sharing mechanisms are assumed accounted for in expenditure.

### III. Calibrating Operational (Deficit) Rules and Pace of Adjustment
- Debt dynamic framework used to determine deficit paths allowing debt to converge from current level to debt anchor.
- Illustrative hypothetical scenario (Table 2 parameters):
  - Small open economy.
  - Current government debt: 80 percent of GDP.
  - Prudent debt anchor: 50 percent of GDP.
  - Time horizon to achieve anchor: 15 years (user-adjustable).
  - Current overall deficit: 5 percent of GDP.
- Flexibility on pace of adjustment:
  - Users can model gradual adjustment; illustrative initial fiscal adjustment period: five years.
  - Given Table 2 parameters, long-term convergence example requires:
    - Overall deficit to adjust by 0.7 percent of GDP annually over the first four years (or primary deficit at 0.5 percent of GDP) and then maintain that deficit level to lower debt from 80 percent to 50 percent of GDP.
  - Immediate adjustment alternative (2018 toolkit): tightening of 2.6 percent of GDP in overall deficit or 2.0 percent of GDP in primary deficit in the first year.
  - Convergence to the debt anchor at a given date (15 years) implies annual reduction of overall deficit of about 1 percentage point of GDP in the first four years.
- Key macro parameters (Table 2, exact entries):
  - A. Macroeconomic Parameters
    - Current debt ratio (% GDP): 80 80 80
    - Target debt ratio (% GDP): 50 50 50
    - Long-term nominal interest rate (%): 3 3 3
    - Long-term nominal growth rate (%): 5 5 5
    - Current fiscal balance (% GDP):
      - Primary balance: −3 −3 −3
      - Overall balance: −5 −5 −5
  - B. Parameters on the Pace of Adjustments
    - Convergence period for debt (years): 15 20 20
    - No shock gradual adjustment period: 4 — —
    - Yearly primary and overall balance adjustment (% GDP): 1 — —
    - Initial fiscal adjustment period (years): 5 5 5
  - C. Parameters on Climate Investment
    - Period until climate investment spending rise (years): 6 6 6
    - Long-term incremental climate investment spending (% GDP): 0.2 0.2 0.2
    - Long-term early or constant climate investment spending (% GDP): 1 1 1
    - Climate investment spending in the initial adjustment period (% GDP): 1 1 1
  - D. Parameters on the Natural Disaster Shocks
    - Years of natural disaster: — 3 3
    - After shock gradual adjustment period: — 5 5
    - Yearly primary and overall balance adjustment (% GDP): — 2 2
    - Effect of natural disasters on fiscal balance (% GDP): — −7 −7
    - Climate fund: — 0 1
  - E. Parameters on Mitigation Measures for Natural Disaster Shocks
    - Multiyear grants for natural disaster mitigation (% GDP):
      - Year 1: — 0 2
      - Year 2: — 0 0
      - Year 3: — 0 0

### Incorporating Climate Investment into Deficit Rules
- Toolkit allows multiple investment profiles:
  - Approach 3: upfront investment (front-loading).
  - Approach 4: anticipated incremental investment (back-loading at 0.2 percent per year).
  - Approach 5: constant annual outlay (back-loading at 1 percent of GDP starting year 6).
- Example assumptions:
  - Government undertakes additional climate investment for six years, front-loading at about 1 percent of GDP per year.
- Calibrated impacts (preserve exact outcomes from text):
  - Under front-loading (approach 3): initial pace of adjustment more gradual at an average of 0.7 percent per year (relative to 1 percent in approach 2 with no additional public investment).
  - Subsequent requirement: overall deficit of 0.4 percent of GDP or primary surplus of 1.6 percent of GDP to achieve the debt anchor in 15 years.
  - Back-loading approaches (4 and 5) require annual overall and primary balance adjustment of 1 percent of GDP each (approach 4) or similar patterns with additional savings for larger investment (approach 5).

### Introducing Natural Disaster Shocks into Operational Rules
- Severe disaster scenario in illustrative calibration:
  - Occurs in year 3.
  - Deterioration of fiscal balance by 7 percent of GDP.
  - Recovery period: five years.
- Postshock policy options:
  - Activate escape clause in rules-based framework to provide fiscal support.
  - Toolkit options include extending horizon to reach debt anchor (example: from 15 to 20 years) or suspending ongoing climate investment when disaster hits in year 3.
- Example postshock adjustment path (approach 3):
  - Gradual until reaching a constant overall surplus of 0.2 percent of GDP or primary surplus of 2.5 percent of GDP to reach the debt anchor.

### Effect of Mitigating Mechanisms on Recovery Paths
- Donor support and contingency fund disbursements cushion shocks and reduce fiscal pressures.
- Example mitigation assumption preserved exactly:
  - 2 percent of GDP of grants in the first year and another 1 percent of GDP disbursed from the climate fund.
- Result: public finances recover sooner and faster; rise in debt more modest compared with no mitigation.

### Sensitivity Analysis on Calibrated Deficit Limits (Table 3 exact outcomes)
- Convergence Period n = 15 | Convergence Period n = 20
  - Long-term convergence (approach 1):
    - Primary Balance: −1. 0  (all cells)
    - Overall Balance: −2.4 (all cells)
  - Convergence at specified date (approach 2):
    - No Disaster Shock (n = 15): Primary Balance 1.1; Overall Balance −0.7
    - With Disaster Shock (n = 15): Primary Balance 4.0; Overall Balance 1.6
    - No Disaster Shock (n = 20): Primary Balance 0.4; Overall Balance −1.4
    - With Disaster Shock (n = 20): Primary Balance 1.8; Overall Balance −0.3
  - Front-loading climate investment (approach 3):
    - No Disaster Shock (n = 15): Primary Balance 1.6; Overall Balance −0.4
    - With Disaster Shock (n = 15): Primary Balance 4.9; Overall Balance 2.4
    - No Disaster Shock (n = 20): Primary Balance 0.8; Overall Balance −1.1
    - With Disaster Shock (n = 20): Primary Balance 2.5; Overall Balance 0.2
  - Back-loading incremental climate investment (approach 4):
    - No Disaster Shock (n = 15): Primary Balance 0.0; Overall Balance −1.9
    - With Disaster Shock (n = 15): Primary Balance 3.8; Overall Balance 1.5
    - No Disaster Shock (n = 20): Primary Balance 0.0; Overall Balance −1.9
    - With Disaster Shock (n = 20): Primary Balance 1.9; Overall Balance −0.2
  - Back-loading yearly climate investment (approach 5):
    - No Disaster Shock (n = 15): Primary Balance −0.2; Overall Balance −2. 2
    - With Disaster Shock (n = 15): Primary Balance 3.7; Overall Balance 1.4
    - No Disaster Shock (n = 20): Primary Balance −0.2; Overall Balance −2. 2
    - With Disaster Shock (n = 20): Primary Balance 1.8; Overall Balance −0.3
- Sensitivity conclusions:
  - Except for approach 1, larger calibrated budget balance limits are required after a natural disaster shock to lower debt to the anchor level.
  - Extending convergence period from 15 to 20 years affects deficit rule limits and transition paths.

### Translating Calibrated Deficit Paths into Operational Rules
- Calibrated operational deficit ceilings can be translated into:
  - Expenditure rules (expenditure growth or ratio to GDP) using assumed revenue-to-GDP ratios.
  - Cyclically adjusted primary balance rules that allow automatic stabilizers to fully operate during a typical economic downturn.

*Source: Authors’ estimates and simulations from the Technical Notes and Manuals chapter "Calibrating Fiscal Rules: A Consideration of Natural Disaster Risks."*

### References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

### Calibrating Fiscal Rules: A Consideration of Natural Disaster Risks

### I. Introduction
- Large shocks from natural disasters are a key source of vulnerabilities for public finances in disaster-prone countries, weakening revenue mobilization and increasing priority expenditures, which can raise borrowing and undermine debt sustainability.
- Large natural disaster shocks can cause persistent deviation of GDP from its underlying trend in the medium term, especially in small developing countries.
- Incidence of natural disasters is expected to increase, calling for structural, financial, and postdisaster resilience (including enhancing macro-resilience, adaptation capacity, regional insurance, external grants and financing, and fiscal buffers).
- The fiscal framework can be adapted to: allow governments to meet long-term adaptation investment needs; build or maintain buffers deployable in emergencies; and allow gradual fiscal transition in postdisaster recovery.
- This note extends the 2018 Fiscal Affairs Department calibration toolkit (Eyraud and others 2018) by:
  - allowing inputs to parameterize frequency and intensity of natural disaster risks;
  - modeling asymmetric growth shocks reflecting natural disasters;
  - incorporating mitigating mechanisms such as regional insurance disbursements or external financing; and
  - providing inputs for adaptation investment needs when countries set an expenditure or budget balance rule.
- The revised toolkit seeks a prudent medium-term fiscal anchor and an annual deficit or expenditure path to reach the anchor within a user-specified horizon and is accompanied by two templates for parameterization.

### II. Calibrating the Medium-Term Fiscal Anchor
- Purpose: determine a prudent fiscal buffer so debt will not exceed a specified limit over the medium term under stochastic macroeconomic shocks.
- Extension: flexibility in simulation horizon up to a 10-year forecast horizon (2018 toolkit default was six years).
  - A longer horizon tends to imply a lower debt anchor level (example summary in Table 1, columns A1 and A2).
  - Simulated debt anchor can be sensitive to horizon choice if shock dispersion is large.

### Accounting for Natural Disaster Risks
- Natural disaster shocks are asymmetric with severe downside risks; damages can be large relative to GDP (e.g., a quarter of severe natural disasters caused damage at 10 percent of GDP or higher in the Caribbean between 1970 and 2020).
- Large disasters produce persistent GDP deviations from trend over the medium term.
- Modeling approaches in the toolkit:
  - User can directly specify the growth effect after a disaster (example: assumed to be –5 percent of GDP in Table 1, column B).
  - Stochastic approach: overall growth shock Yt combines typical historical growth shock Yt* with a second component drawn from a Pareto distribution:
    - Yt = Yt*  + ∏Dt·Zt  (Eq. 1)
    - ∏ is the indicator function; Dt ~ Bernoulli(p) with p set exogenously; Zt ~ Pareto with jointly calibrated parameters to match average marginal growth effects and skewness.
  - Pareto distribution cumulative distribution function given in text with scale parameter γ and tail index a as inputs.
- Two-step approach (used in some Eastern Caribbean Currency Union cases):
  - Small natural disaster shocks captured by standard growth shocks.
  - Large natural disaster shocks captured by Pareto distribution calibrated from historical realizations or empirical expectations.
- Effects on debt anchor (illustrative results):
  - Baseline (no natural disaster risks; typical growth shocks follow a normal distribution) → simulated debt anchor: 42.9 percent of GDP (eight-year horizon).
  - Inclusion of natural disaster shocks (probability p = 10 percent; adverse effect –5 percentage points of GDP) → simulated debt anchor: 32.4 percent of GDP (eight-year horizon).
- Sensitivity findings (Table 1 examples):
  - Increasing annual probability of occurrence from 10 percent to 25 percent reduces the debt anchor by around 10 percentage points of GDP (Table 1, column C2).
  - Raising the negative growth effects of a natural disaster by 3.75 percentage points of GDP reduces the debt anchor by 8.40 percentage points to 24 percent of GDP (Table 1, column C3).
  - Doubling risk tolerance from 10 percent to 20 percent raises the prudent debt anchor from 24 to 40 percent of GDP (Table 1, column C4).
- Trade-offs:
  - Higher risk tolerance implies smaller safety buffers but greater readiness to face debt distress or abrupt fiscal adjustments, with potential political and social costs and possible resistance from international partners.

### Incorporating Mitigating Measures of Natural Disaster Shocks
- Complementary mechanisms reduce the need for very large fiscal buffers; examples include:
  - climate or natural disaster funds (Fiji, Grenada, the Philippines, Tuvalu),
  - regional insurance (Eastern Caribbean Currency Union),
  - catastrophe bonds (Barbados and Mexico),
  - African Risk Capacity,
  - Catastrophe Containment and Relief Trust (IMF),
  - Catastrophe Deferred Drawdown Option (Cat DDO) (World Bank).
- Toolkit integration:
  - User specifies size X percent of GDP for a fund; if at least one disaster occurs during the forecast horizon N, the fund disburses (X/N) percent of GDP annually when activated.
  - Disbursements mitigate the lower primary balance effect after disaster, limiting debt increase and reducing required debt anchors.
- Illustrative example:
  - With a disbursement of 5 percent of GDP from other mechanisms, simulated debt anchor would be 40 percent of GDP, relative to 24 percent of GDP in absence of insurance mechanisms (Table 1, columns C3 and D).
- Country example—Grenada (details from text):
  - contingency fund with freely available cash reserves about 2.5 percent of GDP;
  - contingent coverage up to 3.5 percent of GDP;
  - Cat-DDO approval of 1.7 percent of GDP by the World Bank;
  - budgetary contingency about 2 percent of revenues each year or $15 million Eastern Caribbean dollars;
  - parametric insurance policies (Tropical Cyclones and Earthquakes and Excess Rainfall policies; Caribbean Oceans and Aquaculture Sustainability Facility);
  - negotiated debt service reduction clause in event of a natural disaster;
  - National Transformation Fund’s Contingency Fund reformed in 2019 to define objectives for relief, reconstruction, and recovery; rules of accumulation; governance and accountability arrangements.
  - Note: payments for risk-transfer/sharing mechanisms are assumed accounted for in expenditure.

### Table 1 — Selected Parameters and Simulation Outcomes (excerpted figures preserved exactly)
- Last year debt-to-GDP: 48.3 (across scenarios listed as 48.3 or 48.34 in table)
- Debt limit: 60.0
- Forecast horizon examples: 6, 8
- Risk tolerance examples: 10.0, 20.0
- Average historical growth rate: 3.3
- Average historical primary balance: −1.2
- Natural disaster occurrence in scenarios: No / Yes
- Probability of occurrence examples: 10, 25
- Average growth impact examples: 5, 5.8, 7.5 (as shown in columns)
- Pareto: scale parameter examples: 0.042, 0.070
- Pareto: tail index examples: 6, 5
- Climate fund disbursement example: 5
- Mean growth shocks (average across simulations): 3.29, 3.25, 2.63, 2.73, 1.98, 2.34, 2.34, 2.34
- Median growth shocks (average across simulations): 3.31, 3.26, 2.85, 2.91, 2.23, 2.86, 2.86, 2.86
- Skewness growth shocks (average across simulations): −0.01, 0.01, −0.32, −0.22, −0.26, −0.52, −0.52, −0.52
- Mean primary balance (average across simulations): 0.28, −0.09, −1.11, −1.19, −2.18, −2.05, −0.43, −0.48
- Debt anchor outcomes (selected): 46.5, 42.9, 33.0, 32.4, 22.5, 24.0, 39.6, 39.9
  - Note from text: baseline simulated debt anchor is 42.9 percent of GDP at an eight-year horizon; with natural disasters (probability 10 percent; adverse effect −5 percentage points) simulated debt anchor is 32.4 percent of GDP at an eight-year horizon.
- Simulation assumption illustrated: debt limit set at 60 percent of GDP; simulation seeks prudent level of debt such that debt will only exceed the limit at a given risk tolerance (assumed 10 percent).

### Key Findings and Policy Implications
- Natural disaster risks materially lower prudent debt anchors compared with baselines that omit disaster risks (example: from 42.9 percent to 32.4 percent of GDP in illustrative simulation).
- Probability and severity of natural disaster shocks substantially affect required fiscal buffers; higher frequency or severity implies substantially lower debt anchors.
- Mitigating instruments (climate funds, insurance, Cat DDOs, catastrophe bonds, regional pooling) can materially reduce the needed debt anchor and fiscal buffers; a 5 percent of GDP disbursement example raises the debt anchor from 24 percent to 40 percent of GDP in the illustrative scenario.
- Policy trade-offs involve choosing risk tolerance levels: lower tolerance requires larger buffers; higher tolerance raises social and political risks and may conflict with international financing partners’ expectations.
- Practical approach: combine buffers with risk-transfer and risk-sharing instruments; plan for adaptation investment needs within rules-based frameworks; allow temporary and gradual deviations for reconstruction in postdisaster recovery.

*Source: Authors’ estimates and simulations from the Technical Notes and Manuals chapter "Calibrating Fiscal Rules: A Consideration of Natural Disaster Risks."*

### 1. No Other Insurance or Mitigation Mechanisms

### 1. No Other Insurance or Mitigation Mechanisms

### Overview
- Authors’ simulations illustrate the effect of alternative insurance or mitigation schemes on the debt anchor under severe natural disaster shocks (Figure 2).
- Debt anchor examples shown in figures:
  - Debt anchor: 24.0% of GDP
  - Debt anchor: 39.9% of GDP
  - Debt limit: 60% of GDP

### Calibrating the Operational (Deficit) Rules
- Uses the standard debt dynamic equation to determine deficit paths that allow debt to converge from the current level to the debt anchor.
- Illustrative hypothetical scenario:
  - Small open economy
  - Current government debt: 80 percent of GDP
  - Prudent debt anchor: 50 percent of GDP
  - Time horizon to achieve anchor: 15 years (user-adjustable)
  - Current overall deficit: 5 percent of GDP
- Under baseline macro parameters (Table 2, “A. Macroeconomic Parameters”), other macroeconomic variables match those listed in Table 2.

### Flexibility of the Pace of Fiscal Adjustments
- Toolkit extensions introduce ability to model gradual adjustment; users can decide duration of fiscal adjustments.
- Illustrative initial fiscal adjustment period: five years (user-tailorable).
- Given initial macro parameters in Table 2, long-term convergence would require:
  - Overall deficit to adjust by 0.7 percent of GDP annually over the first four years (or primary deficit at 0.5 percent of GDP) and then maintain that deficit level for remaining periods to lower debt from 80 percent of GDP to 50 percent of GDP.
- Immediate adjustment (as in 2018 toolkit) would require:
  - Sharp tightening of 2.6 percent of GDP in the overall deficit or 2.0 percent of GDP in the primary deficit in the first year.
- Convergence to the debt anchor at a given date (15 years) implies:
  - Annual reduction of overall deficit of about 1 percentage point of GDP in the first four years.

### Illustrative Macroeconomic Parameters (Table 2)
A. Macroeconomic Parameters
- Current debt ratio (% GDP): 80 80 80
- Target debt ratio (% GDP): 50 50 50
- Long-term nominal interest rate (%): 3 3 3
- Long-term nominal growth rate (%): 5 5 5
- Current fiscal balance (% GDP):
  - Primary balance: −3 −3 −3
  - Overall balance: −5 −5 −5

B. Parameters on the Pace of Adjustments
- Convergence period for debt (years): 15 20 20
- No shock gradual adjustment period: 4 — —
- Yearly primary and overall balance adjustment (% GDP): 1 — —
- Initial fiscal adjustment period (years): 5 5 5

C. Parameters on Climate Investment
- Period until climate investment spending rise (years): 6 6 6
- Long-term incremental climate investment spending (% GDP): 0.2 0.2 0.2
- Long-term early or constant climate investment spending (% GDP): 1 1 1
- Climate investment spending in the initial adjustment period (% GDP): 1 1 1

D. Parameters on the Natural Disaster Shocks
- Years of natural disaster: — 3 3
- After shock gradual adjustment period: — 5 5
- Yearly primary and overall balance adjustment (% GDP): — 2 2
- Effect of natural disasters on fiscal balance (% GDP): — –7 –7
- Climate fund: — 0 1

E. Parameters on Mitigation Measures for Natural Disaster Shocks
- Multiyear grants for natural disaster mitigation (% GDP):
  - Year 1: — 0 2
  - Year 2: — 0 0
  - Year 3: — 0 0

### Incorporating Climate Investment
- Toolkit allows specification of climate investment strategies and profiles:
  - Approach 3: upfront investment (front-loading)
  - Approach 4: anticipated incremental investment (back-loading at 0.2 percent per year)
  - Approach 5: constant annual outlay (back-loading at 1 percent of GDP starting year 6)
- Example illustrative assumptions:
  - Government undertakes additional climate investment for six years, front-loading at about 1 percent of GDP per year.
- Calibrated results under front-loading (approach 3):
  - Initial pace of adjustment more gradual at an average of 0.7 percent per year (relative to 1 percent in approach 2 with no additional public investment).
  - Would require a higher budget balance in subsequent periods: overall deficit of 0.4 percent of GDP or primary surplus of 1.6 percent of GDP to achieve the debt anchor in 15 years.
- Back-loading scenarios (approaches 4 and 5):
  - Fiscal savings built up in initial years help smooth burden when climate investment starts.
  - Approach 4 requires an annual overall and primary balance adjustment of 1 percent of GDP each.
  - Approach 5 shows a similar pattern but requires additional savings to finance the larger investment.

### Introducing Natural Disaster Shocks
- Natural disaster scenario details:
  - Severe natural disaster occurs in year 3.
  - Deterioration of fiscal balance by 7 percent of GDP.
  - Recovery period: five years (Table 2, “D. Parameters on the Natural Disaster Shocks”).
- Postshock policy framework:
  - Country activates the escape clause within the rules-based fiscal framework to provide fiscal support.
  - Without other arrangements or extending the horizon, implies much more ambitious and sustained postshock fiscal adjustment.
- Toolkit options:
  - Extend horizon to reach the debt anchor (example: extend from 15 to 20 years after the shock).
  - Suspend ongoing climate investment when disaster hits in year 3.
- Assumed postshock pace of adjustment in an example (approach 3):
  - Gradual until it reaches a constant overall surplus of 0.2 percent of GDP or primary surplus of 2.5 percent of GDP to reach the debt anchor.

### Effect of Mitigating Mechanisms (Grants, Climate Funds, Reinsurance)
- Donor support or disbursements from contingency funds cushion shocks and reduce fiscal pressures.
- Example mitigation assumption:
  - 2 percent of GDP of grants in the first year and another 1 percent of GDP disbursed from the climate fund.
- Results with mitigating resources:
  - Public finances recover sooner and faster.
  - Rise in debt is more modest compared with no mitigation.

### Sensitivity Analysis on Deficit Rules (Table 3)
- Table 3 reports calibrated constant fiscal balance limits (primary and overall) under different approaches, convergence periods (n = 15 and n = 20), and presence/absence of disaster shock.

Convergence Period n = 15 | Convergence Period n = 20
- Long-term convergence (approach 1):
  - Primary Balance: −1. 0  (all cells)
  - Overall Balance: −2.4 (all cells)
- Convergence at specified date (approach 2):
  - No Disaster Shock (n = 15): Primary Balance 1.1; Overall Balance −0.7
  - With Disaster Shock (n = 15): Primary Balance 4.0; Overall Balance 1.6
  - No Disaster Shock (n = 20): Primary Balance 0.4; Overall Balance −1.4
  - With Disaster Shock (n = 20): Primary Balance 1.8; Overall Balance −0.3
- Front-loading climate investment (approach 3):
  - No Disaster Shock (n = 15): Primary Balance 1.6; Overall Balance −0.4
  - With Disaster Shock (n = 15): Primary Balance 4.9; Overall Balance 2.4
  - No Disaster Shock (n = 20): Primary Balance 0.8; Overall Balance −1.1
  - With Disaster Shock (n = 20): Primary Balance 2.5; Overall Balance 0.2
- Back-loading incremental climate investment (approach 4):
  - No Disaster Shock (n = 15): Primary Balance 0.0; Overall Balance −1.9
  - With Disaster Shock (n = 15): Primary Balance 3.8; Overall Balance 1.5
  - No Disaster Shock (n = 20): Primary Balance 0.0; Overall Balance −1.9
  - With Disaster Shock (n = 20): Primary Balance 1.9; Overall Balance −0.2
- Back-loading yearly climate investment (approach 5):
  - No Disaster Shock (n = 15): Primary Balance −0.2; Overall Balance −2. 2
  - With Disaster Shock (n = 15): Primary Balance 3.7; Overall Balance 1.4
  - No Disaster Shock (n = 20): Primary Balance −0.2; Overall Balance −2. 2
  - With Disaster Shock (n = 20): Primary Balance 1.8; Overall Balance −0.3

- Key sensitivity conclusions:
  - Except for approach 1 (long-term convergence), larger calibrated budget balance limits are required after a natural disaster shock to lower debt to the anchor level.
  - Extending convergence period from 15 to 20 years affects deficit rule limits and transition paths.

### Translating Calibrated Deficit Paths to Other Fiscal Rules
- Calibrated operational deficit ceilings can be interpreted as limits in the deficit rule and translated to:
  - Expenditure rules (expenditure growth or ratio to GDP) using assumed revenue-to-GDP ratios.
  - Cyclically adjusted primary balance rules: the cyclically adjusted primary balance ceiling should allow automatic stabilizers to fully operate during a typical economic downturn.

*Source: tnmea2023002 - 1. No Other Insurance or Mitigation Mechanisms (Authors’ simulations and compilation).*

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_Source: https://www.imf.org/-/media/files/publications/tnm/2023/english/tnmea2023002.pdf_