Imagine living in a country where storms, floods, or droughts can cause catastrophic damage to the livelihoods of thousands or even millions of people, undermining a country’s ability to grow and maintain its macroeconomic stability. This is the challenge facing several developing countries all over the world, especially in Latin America and the Caribbean (LAC), where countries are increasingly exposed to natural disasters of significant magnitude. The frequency of extreme natural disasters has risen from 67% during the 2000s to 73% in the last decade, with disasters causing an average damage equivalent to 2.4% of GDP[1].
The connection between climate risks and a country’s fiscal situation might not seem obvious, but it is consequential. When investors perceive a country as vulnerable to climate change, borrowing costs for that country goes up—sometimes significantly. For countries already struggling with elevated levels of debt, this makes it even harder to invest in the solutions they desperately need to address their climate vulnerabilities.
In our recent publication, “Asymmetric Sovereign Risk: Implications for Climate Change Preparation”, we explore how perceptions of climate risk influence sovereign spreads across countries with varying economic conditions. Our findings highlight the asymmetric impact of climate risks on financing costs, particularly for high-risk countries, and emphasize the critical role of investments in climate preparedness, resilient infrastructure, and economic diversification. These investments not only mitigate vulnerabilities but also present a unique opportunity for countries to enhance economic resilience and bolster investor confidence in their capacity to navigate the challenges of a warming planet.
Shedding Light on the Factors Affecting Perceptions of Climate Vulnerability on Sovereign Risk
When disasters strike, they not only devastate critical infrastructure and disrupt lives but also trigger a less visible yet equally harmful impact: heightened perceptions of sovereign risk in international debt markets. This financial ripple effect can significantly increase borrowing costs for affected countries, compounding the challenges they face in rebuilding and strengthening their resilience.
Our research identifies five main characteristics of how investor perceptions of climate vulnerability can affect sovereign spreads:
- Short-Term Debt Spreads Are Most Affected by Perceptions of Higher Climate Vulnerability: When disasters strike, they also amplify perceptions of sovereign risk in debt markets, particularly for short-term maturities. Our findings show that sovereign credit spreads for two-year debt can increase by as much as 23% for high-risk countries following a one-unit rise in climate vulnerability, highlighting the immediate financial repercussions of climate risks.
- Strengthen Fiscal and Institutional Resilience: Governments need to adapt fiscal frameworks to integrate risk stratification strategies that prioritize spending based on the persistence and magnitude of risks. This includes mechanisms for reallocating budgets and evaluating expenditures to create fiscal space for contingencies. Demonstrating a proactive approach to managing climate-related risks can reduce investors’ perceptions of vulnerability and improve access to financial markets.
- Enhance Green Financing and Risk Transfer Mechanisms: Developing sustainable debt markets is crucial for facilitating climate adaptation. This includes advancing green financing strategies, such as climate bonds, contingent funds, and partnerships with the private sector. Establishing a green yield curve and promoting resource-mobilizing instruments will not only help transfer risk effectively but also attract investments into climate-resilient projects, fostering a sustainable financial ecosystem.
- Promote Economic Diversification: Investing in education, technology, and innovation-driven industries is essential for reducing economic vulnerability to external shocks. Economies with greater complexity generate more stable revenues, enhance resilience, and improve access to international debt markets. Diversification is a critical strategy for building long-term economic stability and mitigating the impacts of climate risks.
- Invest in Resilient Infrastructure: Public spending on resilient infrastructure is a long-term investment with immediate and sustained benefits. These projects not only provide protection against disasters but also prevent costly reconstruction and economic disruptions. Resilient infrastructure supports economic growth by creating jobs, attracting investment, and ensuring reliable services. While initial costs may be high, the returns—ranging from disaster preparedness to long-term social and economic stability—make it a cornerstone of sustainable development.
To sum up, our research highlights a troubling asymmetry in how investors price risk: economies with weaker fiscal positions and limited economic diversification face disproportionately higher credit spreads due to climate vulnerabilities. This is especially pronounced in short-term sovereign bonds, with spreads for one- and two-year maturities increasing sharply in high-risk contexts. For economies burdened by high debt levels, this creates a vicious cycle—rising borrowing costs shrink fiscal space, delaying critical investments in climate adaptation and further exacerbating their vulnerabilities.
How to Avoid Falling into the Climate Vulnerability Debt Trap
Addressing the challenges faced by vulnerable economies requires targeted and effective solutions. Here are four actionable strategies to help these economies escape the climate vulnerability–debt trap:
- Strengthen Fiscal and Institutional Resilience: Governments need to adapt fiscal frameworks to integrate risk stratification strategies that prioritize spending based on the persistence and magnitude of risks. This includes mechanisms for reallocating budgets and evaluating expenditures to create fiscal space for contingencies. Demonstrating a proactive approach to managing climate-related risks can reduce investors’ perceptions of vulnerability and improve access to financial markets.
- Enhance Green Financing and Risk Transfer Mechanisms: Developing sustainable debt markets is crucial for facilitating climate adaptation. This includes advancing green financing strategies, such as climate bonds, contingent funds, and partnerships with the private sector. Establishing a green yield curve and promoting resource-mobilizing instruments will not only help transfer risk effectively but also attract investments into climate-resilient projects, fostering a sustainable financial ecosystem.
- Promote Economic Diversification: Investing in education, technology, and innovation-driven industries is essential for reducing economic vulnerability to external shocks. Economies with greater complexity generate more stable revenues, enhance resilience, and improve access to international debt markets. Diversification is a critical strategy for building long-term economic stability and mitigating the impacts of climate risks.
- Invest in Resilient Infrastructure: Public spending on resilient infrastructure is a long-term investment with immediate and sustained benefits. These projects not only provide protection against disasters but also prevent costly reconstruction and economic disruptions. Resilient infrastructure supports economic growth by creating jobs, attracting investment, and ensuring reliable services. While initial costs may be high, the returns—ranging from disaster preparedness to long-term social and economic stability—make it a cornerstone of sustainable development.
A Hopeful Path Forward
The challenges posed by climate change are significant, but they are not insurmountable. Economies most affected by its impacts can turn vulnerability into resilience through well-designed strategies and targeted support.
By preparing for climate risks, diversifying their economic structures, prioritizing investments in resilient infrastructure and innovation, these economies can transform their exposure into strength. This is not merely about weathering the next disaster—it is about laying the foundation for a sustainable future where communities can prosper, regardless of the challenges ahead.
At the IDB Fiscal Management Division, we have developed an extensive agenda to help countries in Latin America and the Caribbean to build their climate resilience through the LAC Regional Climate Change Platform of Economic and Finance Ministers. To learn more how the IDB works with governments to strengthen their fiscal balances visit our Fiscal Management page. We also invite you to visit our Climate Change Dashboard on FISLAC, where you can find not only related data but also macro-fiscal analyses.
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[1] FISLAC estimates based on EMDAT data base.
[2] Gomez-Gonzalez, J. E., Uribe, J. M., & Valencia, O. M. (2023b). Does economic complexity reduce the probability of a fiscal crisis? World Development, 168, Article 106250.
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