The Influence of Political Stability on Fiscal Space Amidst Climate Risks

Climate risks have a profound impact on fiscal space, with sovereign bond yields and debt ratings serving as indicators of the financial challenges. The role of political stability and financial development in reducing these risks is pivotal, highlighting their significance for fiscal sustainability in the long run.

Climate risks, encompassing the potential negative socio-economic consequences of climate change, pose considerable fiscal threats, particularly through their impact on fiscal space. For instance, a major disaster triggered by climate change could require substantial fiscal expenditures for relief and recovery efforts.

Similarly, extreme heat due to global warming might lead to significant agricultural damage, prompting governments to offer subsidies to affected farmers. Broadly, public spending on climate change adaptation and mitigation stands as one of the largest fiscal demands globally.

Combined with other significant fiscal demands, such as those stemming from an aging population, climate change-related fiscal expenditures pose a substantial threat to fiscal space and sustainability in the future.

A recently published ADB Economics Working Paper analyzes the effect of climate risk on fiscal space across 199 countries from 1990 to 2022. We measure fiscal space using sovereign bond yields and ratings on foreign currency long-term sovereign debt. Elevated sovereign bond yields and downgraded sovereign debt ratings signal higher borrowing costs and default risks, indicating a deterioration in fiscal space.

We also explore the mitigating role of political stability and financial development in climate-related fiscal risks. Specifically, we assess whether more politically stable and financially developed economies are less susceptible to these risks.

Political stability is likely to reduce these risks as it increases the probability of more sustainable fiscal policies, such as a robust medium-term fiscal framework. Consequently, a more stable political environment is likely to lessen the impact of climate shocks and other shocks on fiscal sustainability.

Moreover, political stability fosters more cautious, rational, and cost-effective government planning in response to potential climate shocks, helping to preserve fiscal space.

Financial development is also anticipated to reduce climate-related fiscal risks. In financially developed economies, businesses and households have access to insurance and other financial instruments that protect them from the adverse effects of climate shocks.

This reduces the need for substantial fiscal outlays, thereby mitigating the negative impact on fiscal space. Additionally, financial development increases the credit available to businesses and households to help them absorb the effects of potential climate shocks.

Our findings reveal that a one-unit increase in climate vulnerability results in a significant one percentage point increase in bond yields in countries with high political stability risks, peaking at 2 years post the initial impact. Conversely, in countries with lower political stability risks, the response of bond yields is not statistically significant.

In the case of financial development, economies with low financial development are more vulnerable to climate-related sovereign risks. Bond yields rise by approximately 0.6 percentage points for these economies, peaking at 2 years post the initial climate shock. Meanwhile, in economies with high financial development, no significant effect is observed.

Overall, our empirical analysis indicates that climate vulnerability negatively affects fiscal space, with the most pronounced effects in countries most susceptible to climate change and where fiscal space is most limited. We also find that these effects are reduced in countries with more stable political environments and more developed financial markets.

More specifically, our evidence shows that climate risks are associated with lower bond risk premiums and higher sovereign ratings in countries with less exposure to both external and internal conflict.

Furthermore, better financial development weakens the link between climate risks and fiscal space. Financially developed countries do not experience a climate-related bond risk premium or a persistent decline in sovereign ratings due to climate vulnerability.

While fiscal consolidation is crucial for mitigating the adverse effects of climate risks on fiscal space, our results suggest that political stability and financial development can also contribute.

Political stability is valuable in its own right, but our analysis provides evidence of a significant additional benefit in protecting fiscal space from climate risk. Similarly, our findings reinforce the argument for governments to promote financial development further.