Bracing for the Typhoon: Climate change and sovereign risk in Southeast Asia

This article investigates and empirically tests the link between climate change and sovereign risk in Southeast Asia. Southeast Asian countries are among those most heavily affected by climate change. The number and intensity of extreme weather events in the region have been increasing markedly, causing severe social and economic damage. Southeast Asian economies are also exposed to gradual effects of global warming as well as transition risks stemming from policies aimed at mitigating climate change. To empirically examine the effect of climate change on the sovereign risk of Southeast Asian countries, we employ indices for vulnerability and resilience to climate change and estimate country-specific OLS models for six countries and a fixed effects panel using monthly data for the period 2002 – 2018. Both the country-specific and the panel results show that greater climate vulnerability appears to have a sizable positive effect on sovereign bond yields, while greater resilience to climate change has an offsetting effect, albeit to a lesser extent. A higher cost of debt holds back much-needed investment in public infrastructure and climate adaptation, increases the risk of debt sustainability problems, and diminishes the development prospects of Southeast Asian countries. the and sovereign risks stemming from climate change for Southeast Asian countries. To the best of our knowledge, this study is the first to examine climate change dynamics and fiscal transmission channels in Southeast Asian economies with an empirical focus on country-specific implications. To empirically examine the effect of climate change on the sovereign risk of the member countries of the Associa-tion of Southeast Asian Nations (ASEAN), 1 we estimate country-specific OLS models and a fixed effects panel over the period 2002M1 to 2018M12, using indices for climate change vulnerability and resilience to climate change. The country-specific models are estimated for six ASEAN countries: Indonesia, Malaysia, the Philippines, Singapore, Thailand, and Viet Nam. The results indicate that greater vulnerability to climate change has a sizable positive effect on sovereign bond yields, while greater resilience to climate change has an offsetting effect. The climate change risk premium is the highest for Viet Nam, the Philippines, Indonesia, and Thailand. The effect of resilience to risks from climate change has a substantially lower effect on bond yields across all ASEAN economies in our sample. Our findings indicate that those ASEAN countries that are particularly exposed to climate change and have the greatest need to scale up resilience investment face the highest climate change risk premium on their sovereign debt. An increase in sovereign risk worsens the financing conditions of countries and can weaken their development prospects as it constrains fiscal space for investment, not only in crucial areas such as health and education, but also in adaptation measures which are urgently needed to cope with the effects of climate change. With climate change accelerating, and both physical and transition impacts becoming ever more pronounced, climate-related risk premia on sovereign bonds are bound to increase further for climate vulnerable countries, undermining debt sustainability and much-needed investment in resilience.

Southeast Asian economies are also exposed to gradual effects of global warming as well as transition risks stemming from policies aimed at mitigating climate change, the development of more climatefriendly technologies, and changes in consumer preferences.
To date, there is still very little analysis on the impacts of climate change on financial and macroeconomic stability in Southeast Asian countries. Moreover, there has been no systematic analysis thus far on the nexus between climate change and sovereign risk in Southeast Asia, even though it has become increasingly clear that the macroeconomic impacts of climate change and hence also the implications for public finances, will be substantial in this region. Understanding the implications of climate change for sovereign risk is of crucial importance at the current juncture as urgent action is needed to better mitigate and manage associated risks and climate-proof public finances, which are already under considerable strain due to the  pandemic. Indeed, the pandemic has highlighted the pressing need to build resilience into our social, economic, and financial systems, and strong and sustainable public finances are crucial for this.
Against this backdrop, this article discusses the macrofinancial and sovereign risks stemming from climate change for Southeast Asian countries. To the best of our knowledge, this study is the first to examine climate change dynamics and fiscal transmission channels in Southeast Asian economies with an empirical focus on countryspecific implications. To empirically examine the effect of climate change on the sovereign risk of the member countries of the Association of Southeast Asian Nations (ASEAN), 1 we estimate countryspecific OLS models and a fixed effects panel over the period 2002M1 to 2018M12, using indices for climate change vulnerability and resilience to climate change. The country-specific models are estimated for six ASEAN countries: Indonesia, Malaysia, the Philippines, Singapore, Thailand, and Viet Nam. The results indicate that greater vulnerability to climate change has a sizable positive effect on sovereign bond yields, while greater resilience to climate change has an offsetting effect. The climate change risk premium is the highest for Viet Nam, the Philippines, Indonesia, and Thailand. The effect of resilience to risks from climate change has a substantially lower effect on bond yields across all ASEAN economies in our sample.
Our findings indicate that those ASEAN countries that are particularly exposed to climate change and have the greatest need to scale up resilience investment face the highest climate change risk premium on their sovereign debt. An increase in sovereign risk worsens the financing conditions of countries and can weaken their development prospects as it constrains fiscal space for investment, not only in crucial areas such as health and education, but also in adaptation measures which are urgently needed to cope with the effects of climate change. With climate change accelerating, and both physical and transition impacts becoming ever more pronounced, climate-related risk premia on sovereign bonds are bound to increase further for climate vulnerable countries, undermining debt sustainability and muchneeded investment in resilience.
The article is structured as follows. Section 2 discusses the nexus between climate change and sovereign risk. Section 3 provides an overview of climate impacts on the Southeast Asian economies and how these may affect sovereign risk. Section 4 presents an empirical analysis of the impact of vulnerability and resilience to climate change on the sovereign bond yields of Southeast Asian countries. Section 5 concludes by discussing the implications of this research for the development prospects of Southeast Asian countries and policy measures that could be taken to address the problem.

| CLIMATE CHANGE AND SOVEREIGN RISK
Testing the relationship between climate change and sovereign risk is a relatively new strand of the literature, with recent empirical work demonstrating that vulnerability and resilience to climate change are important factors driving the cost of sovereign borrowing at the global level Kling, Lo, Murinde, & Volz, 2018). 2 Conceptually, climate change can impact on an economy and public finances-and thus debt sustainability-in several ways . 3 In particular, climate-related natural disasters may have direct fiscal impacts. Government finances and a country's debt sustainability are exposed to different fiscal risks related to natural disasters. The IMF classifies fiscal risk into two categories, namely macroeconomic risks and specific fiscal risks, which may "arise from the realization of contingent liabilities or other uncertain events, such as a natural disaster, the bailout of a troubled public corporation or subnational government by the central government, or the collapse of a bank" (IMF, 2018, p. 95). Macroeconomic risks related to natural disasters and extreme weather include risks of a disruption of economic activity, which may adversely affect tax income and other public revenues and increase social transfer payments (e.g., Schuler, Oliveira, Mele, & Antonio, 2019); changes to commodity prices that could affect revenue or increase spending via fossil fuel or food subsidies; effects on inflation and interest rates through supply or demand shocks; and exchange rate effects (e.g., Farhi & Gabaix, 2016).
There are several explicit and implicit contingent liabilities through which governments are exposed to fiscal risks (Hochrainer-Stigler, Keating, Handmer, & Ladds, 2018;Mitchell, Mechler, & Peters, 2014;Schuler et al., 2019). Physical government assets and public infrastructure may be damaged or destroyed. Governments may hence have to spend on damage repair or reconstruction. Natural disasters may also affect the assets or operations of state-owned enterprises (SOEs). This could diminish the asset value of SOEs or affect dividend payment to the government. Governments may also have to realize contingent liabilities and step in and bail out SOEs that have been hit hard by a disaster (see Bova, Ruiz-Arranz, Toscani, & Ture, 2019). There are also fiscal consequences related to adaptation and mitigation policies (e.g., Bachner, Bednar-Friedl, & Knittel, 2019).
The Global Commission on the Economy and Climate (2016) estimates that globally until 2030, around US$ 90 trillion will have to be spent on infrastructure, including energy, all of which needs to be sustainable and climate resilient.
As regards to broader macroeconomic impacts of climate change, the physical and transition impacts of climate change can cause aggregate supply and demand shocks (Batten, Sowerbutts, & Tanaka, 2016). Supply and demand shocks from extreme weather events, although short-term in nature, can also have lasting impacts on growth (Acevedo, 2014;Klomp & Valckx, 2014) and public finances. Moreover, the supply and demand side effects of gradual global warming and transition impacts can cause fundamental, enduring structural changes to the economy. For many countries, climate change will have profound impacts on their long-run productive capacity and potential output. A country's long-term growth potential will inevitably have ramifications for public finances, including through effects on sovereign bond yields, and debt sustainability.
Climate-related risks can also impact upon sovereign risk through the negative effect on financial sector stability. Acute physical risks, such as extreme weather events, and chronic physical risks, such as worsening water stress or sea level rises, can result in direct damage to operating assets and reduce the production output of borrowers.
The reduction in borrowers' operating margins and cash flows and the value of collateral assets can lead to credit downgrades, a higher probability of default, and a reduction in the secondary market value of loans held on bank balance sheets. In more severe situations, borrowers will not be able to meet their debt service obligations, resulting in a higher incidence of nonperforming loans and a higher loss given default due to the reduced value of collateral assets. Moreover, investors may suffer from stranded asset risk (Semieniuk, Campiglio, Mercure, Volz, & Edwards, 2021). Financial sector instability may require public bailouts that could affect the solvency of the government and trigger a "doom loop," where a worsening of the sovereign risk profile and a decline in the prices of government bonds further deteriorate banks' balance sheets.
The price of sovereign risk can also be affected by climate change through the effect on international trade and capital flows (e.g., Dellink, Hwang, Lanzi, & Chateau, 2017;UNCTAD, 2019;Wilbanks et al., 2007;WTO and UNEP, 2009 Climate change can also exacerbate social tensions and resource conflicts and thereby undermine political stability, which in turn can detrimentally affect sovereign risk profiles. Notably, political instability can undermine the ability or willingness of a government to repay its debt. For instance, Clark (1997) emphasizes the potential impact of political events on the probability of sovereign default, while Cuadra and Sapriza (2008) maintain that countries that are politically unstable and more polarized have higher default rates and are as a result charged a higher default risk premium in international credit markets.

| CLIMATE CHANGE IN SOUTHEAST ASIA
Although the vulnerability to climate change varies significantly across Southeast Asian countries, the region constitutes one of the most climate-vulnerable regions in the world where economic impacts of global warming are predicted to be among the largest (Kompas, Pham, & Che, 2018;Yusuf & Francisco, 2009). In the widely used Climate Risk Index by Germanwatch, which ranks countries according to fatalities and economic losses due to weather-related loss events, four ASEAN countries-Myanmar, the Philippines, Viet Nam, and Thailand-are listed among the 10 countries most affected by climaterelated disasters over the period 1999 to 2018, with Cambodia coming close in 12th place (Table 1). At the same time, Brunei Darussalam and Singapore rank among those countries with the fewest fatalities and least damage. Figure 1 shows a significant increase in the absolute number of extreme weather events in ASEAN since the start of the last century. The increase has been driven by a rapid growth in the number of floods, storms, and landslides.   Southeast Asian countries will not only be exposed to an increase in the frequency and intensity of extreme weather events, but large parts of the region will also suffer from chronic physical impacts such as worsening heat and water stress and sea level rises, which are

| Data and methodology
To empirically examine the effect of climate change on sovereign risk in the ASEAN region, we estimate country-specific OLS models and a fixed effects panel using monthly data over the period 2002M1 to 2018M12. 7 The added value in the analysis undertaken relates to the focus on six ASEAN economies that are particularly exposed to climate change. The country-specific models are estimated for the following ASEAN economies: Indonesia, Malaysia, the Philippines, Singapore, Thailand, and Viet Nam, while the fixed effects panel includes all six countries. This selection of ASEAN countries was imposed by data availability. Our two baseline equations are as follows: Country-specific: Fixed effects panel: where y i is the sovereign bond yield; z i represents two climate change indicators; x i denotes a set of domestic factors; ω denotes global factors; δ i are country fixed effects; and ε i is the error term. In order to mitigate against endogeneity concerns, the variables are lagged by one period. 8 Clustered SEs are used in order to correct for residual problems relating to heteroskedasticity and autocorrelation.  For the domestic controls, we draw on the literature that examines the drivers of sovereign bond yields (e.g., Beirne & Fratzscher, 2013;Edwards, 1984). The vector of domestic factors in Equations (1) and (2) includes the current account/GDP, public debt/GDP, fiscal balance/ GDP, GDP per capita, and GDP growth. In addition, to reflect more highly integrated financial markets at the global level vis-à-vis ASEAN, we also control for global factors. Specifically, we include US bond yields and the Chicago Board Options Exchange's Volatility Index (VIX) as a measure of global financial market volatility. Table A1 in Appendix A presents details of all variables used, including the sources. With the exception of the resilience coefficient in the case of the Philippines, which is also negative but statistically not significant at the Country fixed effects Yes n/a n/a n/a n/a n/a n/a ***p < .01, **p < .05, *p < .1.

| Results
notion that higher fiscal spending per se is not necessarily a problem for the debt sustainability of countries. With regard to the international control variables, higher US bond yields drive up the cost of sovereign debt across Southeast Asia, with the exception of Viet Nam, where the effect is statistically not significant. Last but not least, greater global financial market volatility, as measured by the VIX, increases sovereign bond yields in most cases, although the coefficients for Singapore, Thailand, and Viet Nam are negative and significant for the latter two.
The significance of global risk aversion implies sensitivity in yields to financial crisis and heightened uncertainty in global financial markets.
The relationship between bond yields and the VIX warrants some further discussion. Previous work by Rey (2015)  When comparing the results across six ASEAN countries, it is notable that the magnitude of the effect of vulnerability to climate change on bond yields is highest for Viet Nam, the Philippines, Indonesia, and Thailand. As discussed before, the Philippines, Viet Nam, and Thailand are among the 10 most vulnerable countries in the world. In particular, for Viet Nam, increased vulnerability to climate change equates to a 728-basis point premium on its sovereign bond yield. Interestingly, the effect has been the smallest in Malaysia, whose coefficient estimate is even lower than that of Singapore, generally considered one of the least vulnerable countries.
The effect of resilience to climate change has a substantially lower effect on bond yields across all ASEAN economies in our sample. The coefficients are negative and significant in all cases except for the Philippines, where we find no significant effect. As in the case of vulnerability, the highest effect is evident in the case of Viet Nam, with higher resilience to climate change equating to a dampening effect on bond yields of around 28 basis points. The effect of resilience on the bond yields of the other ASEAN economies amounts to a reduction in yields of less than 10 basis points.
Overall, the findings indicate that those countries that are particu- where an acceleration of global climate change will make the developing countries of Southeast Asia ever more vulnerable, with adverse effects on their sovereign credit profile and a resulting higher cost of debt. A higher cost of capital will, in turn, hold back public investment in growth and development, including crucial investment in climate-resilient infrastructure and other adaptation measures. Over time, there is a risk that a worsening of climate change and associated macroeconomic impacts will further undermine public finances. Moreover, greater climate vulnerability is also holding back the development of the private sector (Kling et al., 2021). The poorer countries in the region face the risk of not being able to finance necessary adaptation measures and, without external support, ending up in this vicious circle of greater vulnerability and worsening public finances and perpetual debt crises.
On the upside, we also find that greater resilience to climate change can partially offset the effect of climate vulnerability on the cost of capital. While the estimated effect of resilience to climate change is substantially lower than that of vulnerability, the analysis provides a very strong rationale for scaling up investment in climate adaptation and resilience. However, with the exception of Brunei Darussalam and Singapore, Southeast Asian countries will need international support to substantially scale up adaptation and resilience investment.
Besides the need to enhance investment in resilience and adaptation, our findings also underscore the need to mainstream climate risk analysis in public financial management. Governments need to consider the potential impacts of climate change on the medium-to longterm quality and sustainability of public finances and seek to mitigate risks. For instance, budget planning should build in fiscal buffers for climate-related risks and develop contingency savings funds. The Philippines, for example, have established a National Disaster Risk Reduction and Management Fund, an example that could be replicated in other countries in the region.
ASEAN countries should also seek to develop regional and international disaster financing mechanisms and risk-pooling arrangements.
The establishment of the Southeast Asia Disaster Risk Insurance Facility-a regional catastrophe risk insurance pool for the Lao PDR and Myanmar-with financial support from Japan, Singapore, and the World Bank in 2018 is a step in the right direction. However, a more ambitious scheme for the whole of developing Southeast Asia will be needed.
ASEAN countries should also discuss with China, Japan, and the Republic of Korea-with whom they form the ASEAN+3 grouping-to mandate the ASEAN+3 Macroeconomic Research Office to developing a surveillance mechanism for climate-related macrofinancial risk for all countries in the region (Volz, 2021 needed to invest in adaptation and resilience will be substantial for all countries of Southeast Asia. However, a failure to make these investments in the near future is likely to result in much greater costs in the future-including in the form of a higher cost of sovereign borrowing.

ACKNOWLEDGEMENTS
The authors gratefully acknowledge financial support from the Inter- its Board of Governors, or the governments they represent.
ENDNOTES data and find that climate change vulnerability also affects the cost of corporate financing and access to finance, controlling for various firmspecific and macroeconomic factors. 7 The use of a fixed effects as opposed to a random effects model for the panel has been justified on the basis of the results of a Hausman test, which rejected the null hypothesis at below the 1% level with a test statistic chi-squared value of 436.51. 8 Other approaches based on instrumental variables could have been applied, although these are fraught with difficulty given the problems of identifying suitable instruments. As regards preliminary analysis, a correlation matrix of the independent variables indicates no concerns about multicollinearity (see Table A4 in Appendix A). Furthermore, stationarity tests based on the ADF test for the country-specific models and the Choi (2001) test for the panel (which corrects for cross-sectional dependence) reject the null hypothesis of a unit root for the variables used in our analysis. Given the large volume of results, these are not provided but are available from the authors upon request. Descriptive statistics are provided in Table A5 in Appendix A, while the dynamics of bond yields and our climate indicators over time are shown in Figure A1 in Appendix A.

Variable Data source Definition
Sovereign bond yield Bloomberg 10-year government bond yield Vulnerability ND-GAIN and Kling et al. (2021) The refined vulnerability measure by Kling et al. (2021) comprises all of the components from the ND-GAIN vulnerability index that are not highly related to economic variables.

Resilience FTSE Russell
Resilience refers to a country's preparedness and actions to cope with climate change.
Current account/GDP OECD and CEIC The current account balance-to-GDP ratio.
GDP per capita The World Bank Real GDP per capita at constant 2010 US$.
Public debt/GDP IMF International Financial Statistics The public debt as a share of GDP, defined as general government gross debt-to-GDP ratio.
Fiscal balance/GDP IMF International Financial Statistics The fiscal balance as a share of GDP, defined as cyclically adjusted primary balanceto-GDP ratio.