Fed: Natural Disasters, Climate Change, and Sovereign Risk

WASHINGTON, July 9 -- The Federal Reserve issued the following white paper by economist Enrico Mallucci entitled "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 Caribbean countries that are frequently hit by hurricanes. I find that hurricane risk reduces government's ability to issue debt and that climate change may further restrict market access. Next, I show that "disaster clauses", that provide debt-servicing relief, improve government ability to borrow and mitigate the adverse impact of climate change on government's borrowing conditions.

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. Grenada 2004, Antigua y Barbuda 2004 and 2009) and the ongoing debate around climate-change adaption strategies. In particular, the increasing frequency and intensity of natural disasters, such as hurricanes and tropical storms, has led economists and policy makers to advocate in favor of "disaster clauses", that allow for a temporary debt moratorium when countries are hit by natural disasters. Using a quantiative model of sovereign default, I study the impact of extreme weather and climate change on the price of government bonds and governments' borrowing and default decisions.

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 Caribbean economy and is employed to quantify the impact of hurricanes on sovereign risk and government's policies. First, I evaluate the impact of extreme weather comparing model predictions in the baseline model with model predictions when hurricane risk is eliminated. I find that extreme weather restricts government's access to financial markets. Absent disaster risk, governments borrow more.

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 Caribbean and in the United States and their projected evolution with climate change.3 This paper pushes this line of research further, as it evaluates the implications of such costs for public finances, the price of government debt, and sovereign risk.

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 Grenada. Section 3 introduces the theoretical model. Section 4 presents the calibration strategy for the quantitative analysis. Section 5 reports quantitative results. Section 6 examines disaster clauses. Finally, section 7 concludes.

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 Caribbean countries that are exposed to hurricane risk. I find that extreme weather restricts government ability to issue debt. The impact of extreme weather on government policies is poised to become even more sizable in the coming years, amid rapid climate change. In the paper, I show that in a scenario in which the frequency of high-category hurricanes increase 90% and their intensity increases, debt-to-GDP ratios decline by more than 15%, on average, with some countries experiencing declines as large as 40%.

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

Alessandria, George, Minjie Deng, and Yan Bai, "Sovereign Default Risk and Migration," Technical Report 2019.

Arellano, Cristina, "Default Risk and Income Fluctuations in Emerging Economies," American Economic Review, 2008, 98 (3), 690-712.

Asonuma, Tamon, Xin Li, Michael G. Papaioannou, Saji Thomas, and Erika Togo, "Sovereign Debt Restructurings in Grenada; Causes, Processes, Outcomes, and Lessons Learned," Journal of Banking and Financial Economics, January 2018, 2 (10), 67-105.

Balteanu, Irina and Aitor Erce, "Linking Bank Crises and Sovereign Defaults: Evidence from Emerging Markets," IMF Economic Review, December 2018, 66 (4), 617-664.

Barro, Robert J., "Rare Disasters, Asset Prices, and Welfare Costs," American Economic Review, March 2009, 99 (1), 243-264.

Belasen, Ariel R. and Solomon W. Polachek, "How Hurricanes Affect Wages and Employment in Local Labor Markets," American Economic Review, May 2008, 98 (2), 49-53.

Bender, Morris A., Thomas R. Knutson, Robert E. Tuleya, Joseph J. Sirutis, Gabriel A. Vecchi, Stephen T. Garner, and Isaac M. Held, "Modeled Impact of Anthropogenic Warming on the Frequency of Intense Atlantic Hurricanes," Science, January 2010, 327 (5964), 454-458.

Bhatia, Kieran, Gabriel Vecchi, Hiroyuki Murakami, Seth Underwood, and James Kossin, "Projected Response of Tropical Cyclone Intensity and Intensification in a Global Climate Model," Jouranl of Climate, 2018, 31.

Deryugina, Tatyana, Laura Kawano, and Steven Levitt, "The Economic Impact of Hurricane Katrina on Its Victims: Evidence from Individual Tax Returns," American Economic Journal: Applied Economics, April 2018, 10 (2), 202-233.

Eaton, Jonathan and Mark Gersovitz, "Debt with Potential Repudiation: Theoretical and Empirical Analysis," Review of Economic Studies, April 1981, 48 (2), 289-309.

Emanuel, Kerry, "Assessing the present and future probability of Hurricane Harvey's rainfall," Proceeding of the National Academy of Sciences, 2017, 114.

Gallagher, Justin and Daniel Hartley, "Household Finance after a Natural Disaster: The Case of Hurricane Katrina," American Economic Journal: Economic Policy, August 2017, 9 (3), 199-228.

Gourio, Francois, "Disaster Risk and Business Cycles," American Economic Review, October 2012, 102 (6), 2734-2766.

Hatchondo, Juan Carlos and Leonardo Martinez, "The politics of sovereign defaults," Economic Quarterly, 2010, 96 (3Q), 291-317.

Holland, Greg and Cindy L. Bruyere, "Recent intense hurricane response to global climate change," Climate Dynamics, 2013, (42), 617 - 627.

International Monetary Fund, "Dominican Republic; Country Report," IMF Staff Country Reports 99/117, International Monetary Fund October 1999.

- "Republic of Moldova; Country Report," IMF Staff Country Reports 99/110, International Monetary Fund September 1999.

Kossin, James P., "A global slowdown of tropical-cyclone translation speed," Nature, 2018, 558 (4), 104-107.

Mejia, Sebastian Acevedo, "Gone with the Wind; Estimating Hurricane and Climate Change Costs in the Caribbean," IMF Working Papers 16/199, International Monetary Fund October 2016.

Nordhaus, William D., "The Economics Of Hurricanes And Implications Of Global Warming," Climate Change Economics (CCE), 2010, 1 (01), 1-20.

Reinhart, Carmen M., Vincent Reinhart, and Christoph Trebesch, "Global Cycles: Capital Flows, Commodities, and Sovereign Defaults, 1815-2015," American Economic Review, May 2016, 106 (5), 574-580.

Richmond, Christine and Daniel Dias, "Duration of Capital Market Exclusion: An Empirical Investigation," SSRN Electronic Journal, 07 2009.

Sturzenegger, Federico and Jeromin Zettelmeyer, Debt Defaults and Lessons from a Decade of Crises, Vol. 1 of MIT Press Books, The MIT Press, August 2007.

Tran, Brigite Roth and Martin J. Wilson, "The local economic impact of natural disasters," Technical Report 2019.

Vos, Rob, Pitou Dijck, Geske Dijkstra, Dougal Martin, and Niek Jong, The Suriname economy: experiences of the 1990s and challenges ahead 11 2000.

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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 Alessandria et al. (2019) also investigate the role of non-economic factors in shaping default risk, studying the impact of political risk and migration on default risk.

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 Roth Tran and Wilson (2019) focusing on impact of hurricanes on local economies.

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The charts, tables and full text of the document can be viewed at https://www.federalreserve.gov/econres/ifdp/files/ifdp1291.pdf

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