ADBI Working Paper Series: Impact of Climate Change on Sovereign Risk in Asia (February 2023)

1. INTRODUCTION

At the macroeconomic level, many argue that the impact of climate change and sovereign risk is interlinked. But very few studies have examined the relationship between climate change and sovereign risk in terms of the wider macroeconomic framework. Because of the increase in sovereign risk, in addition to the existing government debt, is becoming critical in the face of the effects of climate change. Until recently, many policymakers have not considered the impact of climate change on sovereign risk, but in the face of unprecedented climatic events, and their severity and frequency, macroeconomic researchers are seeking the regulation of sovereign risks.

Thus, policymakers argue that the economy needs to have a systematic approach to the climatic impacts in a macroeconomic framework to reduce the spread of government sovereign bonds.

In developing economies, especially in Asia, economic instability and debt sustainability are significant issues in terms of economic growth. In addition, climate change is creating an extra burden for the Asian economies at the macroeconomic level in their efforts to overcome challenges. In the literature, a number of emerging economies in Asia perform differently than the rest of the countries in the world in debt management and sovereign risk management. However, there is limited literature available to investigate how climate change affect sovereign risk to manage the uncertainties of the economy after the impacts of COVID-19.

This paper also aims to identify the transmission channels proposed in the previous literature, such as the macroeconomic impacts of climate change, and climate-related risks and financial sector stability, as shown in the figure below. The key channel for the identification of macroeconomic impacts of climate change is the connection between the physical and transition impacts of climate change and sovereign risk.

Disequilibrium in sovereign bond risk and climate change cause instability in many developing economies. It is essential to evaluate the link between these two factors in terms of increasing climate vulnerability and resilience for macroeconomic policy decisions. This paper intends mainly to apply an econometric model to estimate the impacts of climate change on sovereign risks. With this purpose, the recently developed Panel autoregressive distributed lag (ARDL) model is used to estimate the parameters in Asian markets. First, the paper applies the Pedroni cointegration test to check whether these macroeconomic factors are cointegrated. Then, the Panel ARDL model is employed to estimate the parameters of the model as two groups. The main variable, government sovereign bond spread, is considered an important variable in measuring the risks in order to estimate the coefficients of climate variables while controlling for other determinants. The controlling variables are important to understand the determining factors of the sovereign risks.

Thus, the study examines the factors of sovereign risks in Asia through is empirical evidence. A main consideration of this study is the limited number of existing/available studies in the literature on the link between sovereign risk and climate change at the macroeconomic level in Asia. Understanding the relationship between sovereign risk under climate change vulnerability and resilience in Asia is the main purpose of this study. Thus, this paper adds value to the few empirical studies currently available on climate change impacts on sovereign risk.

The rest of this paper is structured as follows: Section 2 presents the literature review, which includes the theoretical and empirical literature pertaining to sovereign risk and climate change. Section 3 presents data sources and their description. The empirical methodology is explained in Section 4. Section 5 contains the analytical results and discussion. Section 6 provides the conclusion.