Fed: Natural Disasters, Climate Change, and Sovereign Risk
Abstract:
I investigate how natural disaster can exacerbate fiscal vulnerabilities and trigger sovereign defaults. I extend a standard sovereign default model to include disaster risk and calibrate it to a sample of seven
Introduction
Unexpected shocks may tip vulnerable governments in a default. While, the literature has highlighted the fundamental role of macroeconomic and financial shocks, such as a decline of commodity prices (Reinhart et al., 2016) or banking crises (Balteanu and Erce, 2018), in shaping sovereign risk, non-economic shocks, such as political events or extreme weather, are equally important.1 Extreme weather appears especially salient in light of the key role played by natural disasters in recent default episodes (i.e.
Additionally, I show that disaster clauses can improve governments' market access allowing them to borrow more.
I extend a standard sovereign default `a la Arellano (2008) to allow for natural disasters, that are modeled as exogenous shocks. The model is calibrated to a sample of seven
Second, I evaluate the impact of climate change on public finances, investigating how government policies respond to an increase of the frequency and the intensity of hurricanes. I find that governments face worse borrowing conditions when extreme weather becomes more frequent and more intense and, as a result, governments issue less debt leading to a decline of the debt-to-GDP ratios.
Finally, I analyze whether disaster clauses may help. In particular I consider the case of a clauses that allow governments to suspend payments when extreme weather hits. I find that such clauses facilitate market access allowing governments to borrow at better rates.
Yet, disaster clauses also induce governments to engage in "gambling for debt-servicing suspension" behavior. Knowing that debt payments will be suspended in the event of a natural disaster, governments expand borrowings and spreads increase.
Our paper contributes to two main strands of the literature. First, I contribute to the quantitative literature on sovereign defaults in the tradition of Eaton and Gersovitz (1981) and Arellano (2008). In particular, this is the first paper to highlight and quantify the impact of natural disasters and climate change on sovereign risk. In doing so, this paper also highlights the importance of non-economic events in explaining default risk.2 Second, I contribute to the literature that quantifies the impact of disaster risk on asset prices (Barro, 2009) and the macroeconomy (Gourio, 2012). In particular, this paper is related to the work of Mejia (2016) and Nordhaus (2010) that estimate the economic cost of hurricanes in the
The rest of the paper is organized as follows. Section 2 presents background information on the interaction between sovereign risk and extreme weather with a special emphasis on
Concluding Remarks
This paper investigates the impact of extreme weather on government's borrowing and default policies through the lens of a quantitative sovereign default model. In particular, I focus on a sample of small
Next, I explore whether disaster clauses, that allow governments to suspend payments in the event of natural disasters, can facilitate government access to international financial markets. I find that disaster clauses reduce borrowing terms, allowing government to issue more debt. I also highlight that hurricane clauses induce governments to engage in "gambling for debt-servicing suspension" as they reduce the effective cost of repaying the debt. Finally, I show that hurricane clauses only protect governments against an increase in the frequency of extreme weather events, while they are less suited to protect governments against an increase in the intensity of extreme weather events.
Two of the modeling assumptions are worth discussing. Throughout the paper, it is assumed that the pool of investors that buy government bonds does not change after the introduction of the disaster clause. Yet, complex bonds that entail a disaster clause may only appeal to sophisticated traders. If this is the case, the potential pool of investors may become smaller and the benefits of disaster clauses may be smaller. The second assumption is about the design of the disaster clause. In the paper it is assumed that the activation of the disaster clause provides full debt-servicing relief. This assumption is consistent with the way disaster clauses are structured in the real world. Yet, results may change if the debt-servicing relief was only partial or proportional to the severity of hurricanes. In general, further research is needed to identify the optimal design of disaster clauses.
Concluding, this paper takes a first step in the direction of uncovering the unexplored relation between sovereign risk, weather events, and climate change. Several questions, however, remain open. In particular, additional effort should be devoted to investigate the role that official lenders and insurance schemes can play to support governments, amid natural disasters.
This could certainly be an area for interesting future research.
References
Arellano, Cristina, "Default Risk and Income Fluctuations in Emerging Economies," American Economic Review, 2008, 98 (3), 690-712.
Asonuma, Tamon,
Balteanu, Irina and
Barro, Robert J., "Rare Disasters, Asset Prices, and Welfare Costs," American Economic Review,
Belasen, Ariel R. and
Bender, Morris A.,
Bhatia, Kieran,
Deryugina, Tatyana,
Eaton, Jonathan and
Emanuel, Kerry, "Assessing the present and future probability of Hurricane Harvey's rainfall," Proceeding of the
Gallagher, Justin and
Gourio, Francois, "Disaster Risk and Business Cycles," American Economic Review,
Hatchondo, Juan Carlos and
- "
Kossin, James P., "A global slowdown of tropical-cyclone translation speed," Nature, 2018, 558 (4), 104-107.
Mejia,
Nordhaus, William D., "The Economics Of Hurricanes And Implications Of Global Warming," Climate Change Economics (CCE), 2010, 1 (01), 1-20.
Reinhart, Carmen M.,
Richmond, Christine and
Sturzenegger, Federico and Jeromin Zettelmeyer, Debt Defaults and Lessons from a Decade of Crises, Vol. 1 of
Tran,
Vos, Rob, Pitou Dijck, Geske Dijkstra,
* * *
Footnotes:
1/ The ongoing COVID-19 pandemic is also an example of a non-economic shock that may exacerbate existing fiscal weaknesses.
2/ Hatchondo and Martinez (2010) and
3/ Other related papers are Belasen and Polachek (2008) focusing on the impact of hurricanes on wages and employment; Deryugina et al. (2018) and Gallagher and Hartley (2017) focusing on the impact of hurricanes on household income and finances; and
* * *
The charts, tables and full text of the document can be viewed at https://www.federalreserve.gov/econres/ifdp/files/ifdp1291.pdf
* * *
[CaptureJuly09]
Speaker Pelosi Issues Statement on Supreme Court Ruling on Affordable Care Act Contraceptive Coverage Case
Rep. Larson Condemns Supreme Court Ruling Restricting Contraceptive Access
Advisor News
- Year-end planning errors retirees should avoid
- Social cultivation: How to talk with wealthy prospects
- How important is a written financial plan?
- Coalition wants to advise people impacted by policy changes in new administration
- Diagnosing miscommunication in retirement planning
More Advisor NewsAnnuity News
Health/Employee Benefits News
- Best’s Market Segment Report: AM Best Assigns Negative Outlook to US Medicare Advantage and Medicaid Managed Care Government Programs Segment
- Curative Releases a New Study Revealing a Healthcare Affordability Crisis in Georgia: Even the Insured Can’t Afford Care
- The price of Ozempic
- Department of Financial Regulation warns of potential health insurance scams
- Some health care, retirement policies have bipartisan support going into 2025
More Health/Employee Benefits NewsLife Insurance News