Very honored to contribute my fourth guest blog post on Econbrowser. I am deeply grateful to Menzie Chinn.
The recent literature establishes that climate risk reduces the fiscal space, see Beirne et al. (2021) for example. The rationale is intuitive and easy to understand. Financial markets will price the impact of climate risk in the form of higher bond yields and lower ratings on long-term foreign currency debt. This climate risk premium will have important negative implications for the financing of the green transition, especially for emerging markets. However, the literature has not explored the role of financial development and political stability on the climate risk premium. Intuitively, it seems reasonable to think that countries with better financial systems and a more stable political environment will experience smaller pressures on their fiscal space. In a recent paper with John Beirne, Donghyun Park, Jamel Saadaoui, and Gazi Salah Uddin, we investigate this issue. For a sample of 199 economies in 1990-2022, we first empirically confirm that climate risks adversely affect fiscal space. We find that such effects are most pronounced for economies most vulnerable to climate change. However, our evidence indicates that political stability and financial development can mitigate such effects. We also identify nonlinearities in the climate risk-fiscal space nexus. More specifically, the impact of climate risk on fiscal space is greater when fiscal space is most constrained, i.e., at the upper quantile of the distribution.
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