Climate change impact on global stability

Are we underestimating the impact of climate change on global stability? What are the potential consequences for the global economy? What might happen if a country with deep global ties is hit by a large climate shock, and what can we do about it?

The window for addressing the climate crisis is rapidly closing, and climate-related disasters are becoming more frequent and more damaging. Global temperature rise continues to accelerate, while global economic losses from climate-related and natural disasters have reached staggering proportions. When climate shocks hit systemic countries, the effects can spread across borders and even affect the global economy.

As a result, we decided to investigate the impact of climate shocks on the global economy through the lens of global trade and financial networks. Our study includes 85 countries that account for roughly 85% of global GDP. Using the ND-GAIN Country Index, we identified six countries with large GDPs that are also highly vulnerable to climate change.

Three of these countries are systemic, meaning they are deeply interconnected via global networks. Our research shows that a large-scale climate shock in any of these countries will significantly worsen the impact of its external position. This could result in a $300 billion increase in their external financing needs. This result is broadly consistent with what the UN IPCC and IMF country teams have reported. Storms and heavy rains have already reduced the country's real GDP, harmed its fiscal capacity, and harmed its current account.

We have seen many historical examples where countries cannot easily access global financial markets and have had to suspend payments on their external debt. This would have spillover effects on other countries through direct trade and financial links, increasing their external financing needs. If these countries face financial constraints as well, the spillover effects may spread to other economies, including those with no direct links to the country that was hit by the climate shock.

Two factors could amplify the spread. First, as financing needs rise, sovereign risk premia rise, making borrowing more expensive for this country. Second, investors may perceive countries with similar risk profiles as a bad investment, pricing the value of their assets, and thus increasing financing needs.

Our research shows that in a tail risk scenario in which a system a country hit by a climate shock defaults on their external debt, overall global financing increases by around $2 trillion.

This is a large number, but it assumes no policy action. So we asked, "What can policymakers do?"

To begin, implement climate change adaptation and mitigation policies. A wide range of issues could help economies become more resilient and achieve net zero emissions by mid-century. According to IMF research, a mitigation package combining gradually increasing carbon prices, green infrastructure investment, and compensation for households can help achieve net zero emissions by 2050 while boosting growth during the post-pandemic recovery.

Second, sound macroeconomic policies, such as flexible exchange rates to absorb shocks and smooth external adjustment, aid in reducing contagion.

Third, countries can have a global financial safety net, with the IMF, along with bilateral and multilateral support, offering financial assistance to deal with economic fallout and prevent the worst-case scenario from becoming a reality.

Because of the interconnectedness of major shocks, economies are currently highly vulnerable. This shock does not have to occur in a major economy like the United States or China; it can occur in a developing economy with significant ties to others, resulting in a major issue that eventually affects the large economies. When considering both domestic and global policy responses, the impact of spillovers on global financing needs could be reduced by more than half.

We cannot overstate the massive impact of inaction in an increasingly interconnected world. Climate change is a looming threat to global economic and financial stability; strong domestic policy action and international cooperation can mitigate this risk. It is time to act!

List of globally interconnected countries from USNews