Why Climate Change Vulnerability Is Bad for Sovereign Credit Ratings
IMF Blog, February 17, 2021
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Bibliographic details
- Authors: Serhan Cevik, Joo Tovar Jalles
- Published: February 17, 2021
Key findings on climate vulnerability and sovereign credit
- Climate change vulnerability and resilience affect sovereign creditworthiness, borrowing costs, and default risk.
- Financial risks created by climate change are felt more acutely by developing economies, especially those lacking policy space to address climate shocks.
- Empirical analysis uses the Notre Dame Global Adaptation Initiative dataset to measure country-level climate vulnerability and resilience.
Evidence from sovereign bond spreads (sample and method)
- Sample: a panel of 67 countries over a period of 1995–2017.
- Outcome: climate change vulnerability has adverse effects on sovereign credit ratings and bond spreads even after controlling for conventional macroeconomic determinants.
Quantified effects on long-term (10-year) government bond spreads
- An increase of 10 percentage points in climate change vulnerability is associated with an increase of about 30 basis points in long-term (10-year) government bond spreads relative to the U.S. benchmark in the sample of 67 countries.
- An improvement of 10 percentage points in climate change resilience is associated with a decrease of 7.5 basis points in long-term government bond spreads.
Heterogeneity by country group (advanced vs. emerging and developing)
- Climate change vulnerability has no significant impact on bond spreads and credit ratings in advanced economies.
- Effects are much greater for emerging markets and developing economies, reflecting weaker capacity to adapt and mitigate climate consequences:
- An increase of 10 percentage points in climate change vulnerability is associated with an increase of over 150 basis points in long-term government bond spreads of emerging markets and developing economies.
- An improvement of 10 percentage points in climate change resilience is associated with a decrease of 37.5 basis points in bond spreads for emerging markets and developing economies.
- On average, the effect in emerging markets and developing economies is five times larger than when all countries are counted.
- The difference between countries in the 25th and 75th quintile amounts to 233 basis points for climate change vulnerability and 56 basis points for climate change resilience.
Link to sovereign default risk
- Sample: a panel of 116 countries over the period 1995–2017.
- Finding: countries with greater vulnerability to climate change face a higher likelihood of sovereign debt default compared to more climate-resilient countries.
- Climate change resilience can decrease the probability of sovereign debt default after controlling for conventional determinants.
Policy implications and recommendations (building resilience)
- Benefits of climate resilience are especially pertinent as countries pursue sustainable recovery from the COVID-19 pandemic.
- Developing economies with limited fiscal capacity could benefit from alternative instruments, including catastrophe insurance and debt-for-nature swaps, to mobilize resources for resilient infrastructure and environmental conservation while reducing the debt burden.
- Recommended actions to ease climate-related strain on public finances and lower borrowing costs:
- Pursue cost-effective climate change mitigation and adaptation strategies.
- Build structural resilience to climate risks, including through resilient infrastructure.
- Strengthen financial resilience through fiscal buffers and insurance schemes.
- Improve economic diversification to reduce excessive reliance on climate-sensitive sectors.
Source: Why Climate Change Vulnerability Is Bad for Sovereign Credit Ratings (IMF blog, Serhan Cevik and João Tovar Jalles, February 17, 2021).