Extreme events and public debt dynamics: Lessons from Croatia's experience

TL;DR

This paper analyzes how extreme natural disasters, like earthquakes, impact public debt trajectories in Croatia, emphasizing the importance of fiscal buffers and integrating disaster stress-testing into debt sustainability analysis.

Contribution

It introduces a novel approach by incorporating natural disaster stress-testing into public debt analysis for small open economies.

Findings

Disaster scenario causes debt to rise sharply and remain elevated.

Under normal conditions, debt-to-GDP declines gradually.

Fiscal buffers are crucial for absorbing shocks.

Abstract

Using Croatian data and the IMF's Natural Disaster Debt Dynamic Tool, this paper assesses how public debt adjusts to extreme events in a small open economy. We compare debt paths under baseline and stress scenarios, the latter simulating a major earthquake in 2025. Croatia provides a unique setting for evaluating post-disaster recovery in countries recently incorporated into the European Union. Our benchmark projections, which assume moderate economic growth and a broadly neutral fiscal stance, suggest the debt-to-GDP ratio will gradually decline to below 55% by 2040. In contrast, in the disaster scenario, we document a sharp short-term increase and a persistent upward shift in the debt trajectory, reaching 75% of GDP. Deterministic and stochastic simulations allow us to assess the distribution of potential outcomes. It is shown that, in the absence of shocks, public debt is on a sustainable downward path, but a severe natural disaster could reverse this trend and keep it elevated for years. Our findings highlight the importance of fiscal buffers that are critical for creating space to absorb shocks. The paper innovates by integrating natural disaster stress-testing into public debt analysis, with implications for fiscal risk management and policy planning. While we focus on Croatia, the mechanisms we uncover have broader implications for small open economies exposed to extreme events.