Economics: Climate change raises Emerging Market’s debt risks

ASR’s Climate Macro Strategy team has shown how climate change can lead to economic implications, including spillover effects to bond and equity markets, with the spillovers to the EM hard-currency bond market possibly being the most severe – since that’s where the physical risks from climate change are highest and governments have the least ability to mitigate the damage.

Both relative poverty and higher exposure to climate change risk may explain why so many countries remain in debt distress, even as hard-currency bond spreads narrow for other EM issuers. The link between poverty and debt default has grown starker in recent years, with exposure to physical climate change potentially being a key contributor.

Mike Penn of our Climate Macro team suggests four ways that physical climate risk can contribute to sovereign default risk: 

1) More severe climate disasters can increase the government’s borrowing needs

2) These governments may need to spend more to adapt to climate change

3) They’re likely to experience more frequent tax revenues losses from environmental disasters

4) Climate-induced migrations and other social impacts can lead to political instability

Poverty exacerbates all these factors because poorer countries tend to have lower fiscal revenues and weaker governance. Although interestingly, our ‘Key Chart’ shows a J-curve relationship between our measures of default risk and climate change risk: the rich, investment-grade countries (Kuwait and Saudi Arabia) may see more fiscal pressure over the longer run as their oil revenues and physical landscapes dry up. That may limit any further narrowing of EMBI spreads.