Climate Defaults and Financial Adaptation

Climate change-induced cyclone activity is likely to cause significant welfare losses and permanent consumption drops in emerging economies, according to this study by senior economists at the Federal Reserve Bank of Richmond.

The research underscores the importance of incorporating financial frictions when assessing the economic consequences of climate change. It also emphasises the need for innovative financial adaptation instruments to mitigate economic impacts, particularly in nations with less developed financial systems and limited insurance coverage.

Authors Toàn Phan and Felipe Schwartzman present a new model  calibrated to Mexico’s economy, which combines climate-disaster risk with sovereign default risk in a growth framework.

Their approach employs a tractable single-state variable method which captures the complex interplay between climate events, debt dynamics and financial frictions. It provides analytical insights into how disaster risks impact debt, default risk and investment dynamics, while simplifying the modelling of investment and default interactions.

The ‘vicious cycle’ amplifying climate shocks

The results demonstrate how climate disasters can trigger a vicious cycle of increased borrowing needs, heightened default risk and diminished investment capacity. This significantly amplifies the long-term economic impact of climate shocks, with effects lasting up to two decades.

“By destroying a country’s capital, a bad disaster shock increases the risk of default and the interest rate spread as functions of debt issuance,” the authors explain. “This shift forces the country to reduce borrowing, further depressing future output and investment … creating a feedback loop that can lead to a persistent reduction in capital stock and output.”

The authors project that a 10% increase in cyclone activity could lead to a welfare loss equivalent to an approximate 1% permanent drop in consumption in Mexico or similar economies. This welfare loss captures long-run impacts, including:

• persistent declines in GDP and national income
• slower capital accumulation
• higher borrowing costs
• increased likelihood of sovereign debt crises

These effects occur exclusively based on increased cyclone risk, before incorporating other facets of climate change, such as rising temperatures or sea-level rise.

Mitigating losses through financial innovation

The study explores two financial adaptation strategies to mitigate losses for emerging economies.

The first is disaster insurance which could enable emerging economies to recover around a fifth of the welfare loss from cyclone risk if a complete disaster insurance market were established. Although insurance yields output gains and facilitates faster recovery, the authors note these benefits are constrained by the cost of premiums.

The second strategy involves catastrophe (or cat) bonds, which provide payouts for specific disasters and offer short-term benefits such as reduced default risk and lower borrowing costs. However, the issuance of cat-bonds follows a Laffer curve, whereby moderate amounts are beneficial but excessive issuance can increase costs. Moreover, cat-bonds are less effective in the long term compared to insurance as they may lead to increased borrowing and lower net worth.

Finally, while the paper focuses on cyclones in Mexico, the authors note that their model could be extended to different climate events and adaptation strategies elsewhere.