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The Influence of Political Stability on Fiscal Space Amidst Climate Risks

2025-08-16 13:27:06 By Eliana Curtis

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.

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Beyond Growth: How AI Can Reshape Economies for Ecological Sustainability

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The recent interest rate cuts by the United States Federal Reserve present opportunities and challenges for central banks in Asia and the Pacific. Policymakers must adopt a balanced, country-specific approach to navigate potential inflationary pressures, exchange rate volatility, and capital inflow dynamics. The United States’ Federal Reserve (Fed) kicked off a long-anticipated monetary policy loosening cycle at its September Federal Open Market Committee meeting, cutting interest rates by 50 basis points. Committee members project another 50 basis points of cuts this year, and that Fed loosening will continue in 2025. This could have significant consequences for the global economy, including for developing economies in Asia and the Pacific. Inflationary pressures in have continued declining in the region this year, as commodity prices stabilized and the lagged effects of last year’s monetary tightening took hold. 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Alternatively, central banks in the region could continue to maintain a relatively tight monetary stance—e.g., by cutting interest rates with a lag and/or less than proportionally with respect to the Fed. In such a case, the lower interest rates in the US could increase capital flows to Asia and the Pacific, as investors adjust their portfolios toward assets with more attractive yields. This could boost equity and bond markets across the region, providing some breathing space to more vulnerable economies. However, capital inflows could also present some challenges, as significant swings in short-term portfolio investment could increase financial market volatility.  Additionally, higher capital inflows may result in exchange rate appreciations vis-à-vis the US dollar in the region. This would benefit economies heavily dependent on oil and other commodity imports, reducing price pressures and improving trade balances. For economies with high US dollar-denominated debt, the depreciation of the US dollar would make it easier to sustain the debt burden. On the other hand, exchange rate appreciations would boost imports, with potentially negative effects on current accounts. In the medium term, stronger currencies could also hamper export growth, particularly for economies reliant on exports of traditional manufacturing goods, such as garments or textiles, which depend mainly on price competitiveness. This variety of potential effects and channels suggests that  policy responses to the Fed loosening cycle in Asia and the Pacific will need to be country-specific and nuanced, and include a combination of the following measures. As well as adjusting interest rates, monetary authorities in the region could rely on targeted measures, such as on banks’ reserve requirements, to affect financial and liquidity conditions. Forward guidance can also be an effective tool to anchor inflation expectations and reduce uncertainty and financial volatility, by clearly laying out the future path of monetary policy for market participants and economic agents. For economies receiving increasing capital inflows, well-developed financial markets are key to absorb the inflows and turn them into productive investment in the domestic economy. Policy action should focus on increasing competition, efficiency, and transparency in the financial sector, with the central bank or other overseeing independent authority providing adequate supervision.  To deal with the risks associated with rising capital inflows, capital flow management measures and macroprudential policies can be used, including measures aimed at mitigating exposure to currency mismatches.  Where capital inflows result in excessive currency appreciation, targeted intervention in foreign exchange markets could help reduce volatility, while also increasing foreign exchange reserves. Fiscal policy could be used the cushion the impact of falling exports. Depending on fiscal space, stimulus could be directed at several objectives, including boosting consumer spending; incentivizing activity in particular sectors with stronger multiplier effects on the rest of the economy; and infrastructure, energy-saving, climate-adaptation, and other projects aimed at addressing structural gaps, which would also boost the economy’s productive potential. The beginning of the Fed monetary loosening cycle brings challenges and opportunities for Asia and the Pacific. Lower interest rates in the US and a weaker dollar could lower import costs, boost financial markets, and spur larger capital flows toward the region. But these positive developments would not be without risks, including possible exchange rate volatility and renewed inflationary pressures. Policymakers will need to adopt a flexible approach, remaining vigilant and proactive in taking advantage of the opportunities and addressing the risks.

Digital Currency vs. Cash: A Comparative Analysis

The influence of cutting-edge technology on payment methods extends beyond mere modification; it has ushered in a complete paradigm shift. The Official Monetary and Financial Institutions Forum (OMFIF) has conducted an in-depth review of future payment methods. The widespread ownership of mobile phones and the advancements in telecommunications technology are crucial drivers of the digital economy. Retail and private enterprises are experiencing a burgeoning need for real-time settlement capabilities and low-cost payment solutions. Consumers increasingly value the ability to transfer funds instantly, around the clock. During the COVID-19 pandemic, considerations of public health underscored the efficiency, convenience, universal accessibility, and safety of digital transactions, thereby reducing dependency on cash. Despite these advancements, OMFIF's report, titled "Digital Currency: The Problem of Trust," indicates that cash remains the most favored payment method globally, both in developed and emerging economies. Respondents generally perceive that cash performs optimally across five key dimensions: security, privacy, ease of use, speed, and acceptability. Following cash, credit and debit cards are viewed favorably. Core Attributes and Consumer Preferences When survey participants were questioned about the most desirable features of payment methods, security emerged as the paramount concern across all demographics. Conversely, the speed of transactions was deemed the least critical feature. Digital currencies scored poorly on security aspects while excelling in transaction speed. This discrepancy suggests that for digital currencies to gain widespread acceptance, significant enhancements in security measures are imperative. Security vs. Speed: The Trade-Off The disparity in the perception of security and speed between traditional cash and digital currencies can be attributed to several factors. Traditional cash transactions are tangible and straightforward, offering a sense of security and control to users. In contrast, digital currencies, while offering rapid transaction times and increased efficiency, face challenges related to cybersecurity, fraud prevention, and regulatory oversight. The decentralization inherent in digital currencies further complicates the implementation of robust security protocols. The Future Landscape of Payment Methods The future of payment methods will likely involve a hybrid approach, integrating the strengths of both digital and traditional cash transactions. Enhancements in blockchain technology, cryptographic security, and regulatory frameworks will play pivotal roles in bolstering the security and reliability of digital currencies. As these improvements materialize, digital currencies may begin to rival traditional cash in terms of security, thereby gaining greater acceptance among consumers and businesses alike. In summary, while digital currencies offer unparalleled speed and efficiency, their widespread adoption is contingent upon addressing significant security concerns. Traditional cash remains a steadfastly trusted medium due to its perceived security, privacy, and ease of use. Future advancements in technology and regulatory measures will be crucial in bridging the gap between digital and traditional payment methods, fostering a more integrated and secure financial ecosystem.

A Comprehensive Guide to Currency Risk

Currency risk, also known as exchange-rate risk, pertains to the uncertainty faced by investors and businesses regarding fluctuations in the value of one currency relative to another. This type of risk is a potential source of both profit and loss for international investors or companies engaged in global operations. Institutional investors, including hedge funds, mutual funds, and multinational organizations, frequently employ various financial instruments such as foreign exchange (forex), futures contracts, options contracts, and other derivatives to manage and mitigate currency risk. Understanding Currency Risk Businesses and individuals engaged in international transactions are inherently exposed to currency risk. Hedge funds, mutual funds, and large multinational corporations utilize the forex market and derivatives like futures and options to hedge against currency fluctuations. Hedging strategies involve offsetting potential losses from currency movements. For example, a U.S. investor holding Canadian stocks will see their returns influenced by both the performance of the stocks and the exchange rate between the Canadian dollar (CAD) and the U.S. dollar (USD). If the CAD depreciates against the USD by the same amount as the stock gains, the investor's profit is effectively neutralized after accounting for trading costs. Examples of Exchange-Rate Risk U.S. investors can hedge against currency risk by investing in countries with appreciating currencies and favorable interest rates. However, inflation rates and national debt levels must be considered, as high debt often precedes inflation, potentially leading to currency depreciation. Countries with low debt-to-GDP ratios tend to have stronger currencies. For instance, the Swiss franc (CHF) is supported by Switzerland's political stability and low debt-to-GDP ratio. Similarly, the New Zealand dollar (NZD) benefits from robust agricultural and dairy exports, contributing to potential interest rate hikes. Conversely, a weakening USD, often due to lower U.S. interest rates compared to other countries, generally benefits foreign companies. Bondholders are particularly vulnerable to currency risk due to typically lower returns. Currency fluctuations can significantly impact the returns on a foreign bond index. Bonds denominated in USD provide more stable returns by eliminating currency exposure, while portfolio diversification across various regions mitigates currency risk. Investors may also find opportunities in countries like China, which pegs its currency to the USD. However, central banks could alter these pegging relationships, potentially impacting investor returns. Unique Conditions Various exchange-traded funds (ETFs) and mutual funds are designed to hedge against forex, options, and futures market volatility. Many currency-hedged funds have been established in developed and emerging markets due to the strengthening dollar. These funds typically incur higher costs compared to non-hedged funds, affecting overall returns. BlackRock's iShares, for example, offers a range of currency-hedged ETFs. As the USD depreciated in early 2016, investors reduced their holdings in these funds, leading to the closure of several currency-hedged ETFs. Risk-Free Simulation Engage in virtual trading with $100,000 in play money using our no-risk simulator. Compete against thousands of Investopedia users to hone your trading skills in a simulated environment. This experience will prepare you for success in real financial markets, allowing you to trade like a professional. Interrelated Concepts Transaction risk, arising from forex rate fluctuations before settlement, is a specific type of currency risk. Systemic risk in the market, encompassing broader financial loss potential, and investment risk, defined as the divergence of actual returns from expected outcomes, are also crucial considerations. The forex market operates as a decentralized platform for global currency exchange. A currency peg occurs when a government or central bank maintains a fixed exchange rate between its currency and another, influencing currency risk dynamics. Conclusion Effective management of currency risk is essential for international investors and businesses to safeguard their returns. By employing hedging strategies and diversifying investments, entities can mitigate the adverse effects of currency fluctuations. Understanding and navigating currency risk are fundamental to achieving financial stability and optimizing global market opportunities.