Why climate change vulnerability is bad for sovereign credit ratings?

A sovereign credit rating is an independent assessment of the creditworthiness of a country. Understanding the effects of climate change on credit ratings could guide countries to borrow safely, while understanding its costs.

IMF analysed vulnerability and resiliency data developed by the Notre Dame Global Adaptation Initiative. It includes data of 67 countries from 1995 through 2017.

According to the report, an increase of 10 percentage points in climate change vulnerability resulted in an increase of 30 basis points in 10-year government bond spreads with respect to the US benchmark.

However, an improvement of 10 percentage points in climate change resiliency resulted in a decrease of 7.5 basis points in the 10-year government bond spreads.

While vulnerable advanced economies show no significant impact on their bond spreads, the case is reverse for developing economies.

"Climate change vulnerability has no significant impact on bond spreads and credit ratings in advanced economies, but the effect on emerging markets and developing economies is much greater—due largely to weaker capacity to adapt to and mitigate the consequences of climate change," the report stated.

If climate change vulnerability increases or decreases by 10 percentage points, then the bond spreads increase or decrease by five times more than when all the countries were counted.

Increasing vulnerability by 10 percent points results in an increase of 150 basis points in bond spreads. Similarly, if resiliency improves by 10 percentage points, then bond spreads decreased by 37.5 basis points.

A similar link was found between climate change and sovereign default.

The data of 116 countries between 1995-2017 showed that countries with greater vulnerability to climate change face a higher likelihood of debt default than the resilient countries.

“Our empirical results also indicate that climate change resilience can decrease the probability of sovereign debt default compared to those countries more vulnerable to climate change, after controlling for conventional determinants of sovereign defaults,” the report said.

The report suggests how developing countries can become resilient even as they seek a sustainable recovery from the effects of the pandemic.

Developing countries could benefit from alternative instruments such as catastrophe insurance and debt-for-nature swaps, the report says. These instruments were designed to mobilize resources for protecting nature while reducing the debt burden.

The report suggests pursuing cost-effective climate change adaptation strategies, strengthening infrastructure and financial resilience through fiscal buffers.