The Earth's average temperature has warmed by about one degree (10) Celsius above pre-industrial levels, according to the most recent data by NASA. This change, although seemingly insignificant, has translated into a rapid global torrent of climate abnormality, followed by increasingly frequent and catastrophic natural disasters. On a macroeconomic level, climate change risks can be characterised as: (i) 'physical risks', arising from the economic losses and fatalities of unanticipated and extreme weather events, and (ii) 'transition risks', induced by uncertainty and policies during the transformation to a carbon-neutral economy. How would these two risks impact economic growth and trade, particularly in the many developing and climate-vulnerable nations in South Asia? This article intends to examine this question, along with its policy implications, with a focus on the BoP.
PHYSICAL RISKS: Rising temperatures, amid intensifying cyclones, flooding, and saltwater intrusion among others, threaten agricultural output in terms of both land and labour productivity. This paints out a vivid picture of Bangladesh, a low-lying country with an economically-significant agricultural sector - ranked in the Germanwatch's Global (Long-Term) Climate Risk Index 2021 as the seventh most vulnerable country to physical risks. An International Monetary Fund Country Report on 'Climate Change Mitigation and Adaptation in Bangladesh: Policy Options' (dated September 2019) outlines that in 2017, extreme flooding alone had impacted over 8 million people and led to severe crop destruction in Bangladesh. This, subsequently, prompted a drastic increase in food imports which largely contributed to the deterioration of its current account deficit in the fiscal year, FY2016-2017: from US$1331 million to US$9780 million; turning the overall BoP from a surplus of US$3169 million to a deficit of US$885 million (for the first time since FY2001).
Moreover, weather catastrophes would take a toll on the tourism industry as well. The destruction of natural heritages and tourism infrastructures lowers tourism demand and risks triggering insurance premium hikes - thus hampering the survival of small and medium-sized businesses in the industry. Accordingly, the prospective BoP complications driven by climate change can be illustrated by the COVID-19 pandemic shock that has affected many developing, tourism-dependent economies severely. Taking Vietnam as an example, the International Monetary Fund Country Report on the '2020 Article IV Consultation' with Vietnam highlights that a fall in the country's tourism receipts (and remittances) has led to a diminishing current account surplus throughout the FY2020 - starkly contrasting the increase from 1.9 to 3.8 per cent of GDP in the previous FY.
Altogether, collapsing agriculture and tourism exports may coincide with reduced local infrastructure investment (leading to lower future output) and weaker foreign exchange inflows - in turn, sowing potentially persistent BoP deficits through the current (trade) account. As argued in a Swiss Re Institute publication titled 'The economics of climate change: no action not an option': developing nations, owing to a high economic dependence on these sectors along with weak mitigation capacity, are often the ones to bear the brunt of such physical risks. This, by implication, dampens growth prospects while reinforcing vicious poverty cycles.
TRANSITION RISKS: In much of current literature, the term 'transition risks', usually viewed at the firm level, depicts the situation in which fossil fuels are treated as 'stranded assets' in capital markets during the global shift toward cleaner, renewable energy sources - fuelled by concerns about structural and policy changes aimed at mitigating climate change. This would consequently erode the value of businesses and industries that produce or operate on such fossil fuel-based commodities. Thus, shedding light on the potentially dire macroeconomic problems that transition risks may introduce on an economy-wide level.
The latest statistics by the World Bank depict the proliferation of carbon pricing instruments as policymakers worldwide recognise the need to disincentivise (internalise the cost of) greenhouse gas emissions - namely, in 46 countries as of September 2022. This comprises of carbon taxes and cap-and-trade systems, which each directly translates into higher production costs and restricted supplies of fossil fuels, respectively. Simultaneously, they would dampen firm and export competitiveness in carbon-intensive industries, with repercussions on the rest of the economy (i.e., through higher input costs and utility bills). In addition, a group of researchers at the Boston University, in the policy brief titled 'Climate Change and IMF Surveillance: The Need for Ambition', coin the concept of 'spillover transition risks' to illustrate how transition risks can be further amplified by cross-border trade policies. A prime example is the European Union's proposal for a 'Carbon Border Adjustment Mechanism (CBAM)' that intends to adjust import prices based on their carbon footprints by as early as 2023. This has however been highly contentious, invoking strong accusations of protectionism and the likely trade diversion away from the developing to the developed world - where such carbon pricing mechanisms are already well-established domestically.
Another probable implication is that as the global economy embarks on phasing out fossil fuel consumption, coupled with uncertainty and low market sentiments towards the industry, transition risks would weigh negatively against commodity currencies. Commodity currencies refer to currencies that tend to be closely linked with the world prices of primary commodities, including fossil fuel commodities - owing to the importance of natural resources for aggregate income creation, such as in Malaysia (Malaysian Ringgit). This can be explained using the classic 'Dutch Disease model', devised by Max Corden and Peter Neary in 1982, which outlines that under an expected permanent fall in commodity prices and production, a reduction in natural resource income results in lower overall domestic demand. This lower demand is partly absorbed by lower demand in the internationally non-tradable sectors (services), giving rise to a shift of labor and capital to the internationally tradable sectors (agriculture and manufacturing) as facilitated by an exchange rate depreciation. In line with this, a more recent research paper by the BI Norwegian Business School titled 'Climate Risk and Commodity Currencies' presents empirical findings consistent with the argument that 'when transition risk is high, commodity currencies are likely to experience an episode of persistent depreciation along with a weakened relationship with commodity prices'. From the perspective of a developing, fossil fuel-exporting country, a weaker currency may indicate cheaper but obsolete fossil fuel exports, while imports (typically associated with the high knowledge and technology content/spillovers vital for economic development) become more expensive. Hence, with a shrink in export value and rising import costs, such depreciation is unlikely to translate into an improvement - but instead, a worsening of the current account and the BoP as a whole.
Given the 2015 Paris Agreement to pursue the target of limiting global warming to 1.5 degrees Celsius (and no more than 2 degrees Celsius) from pre-industrial levels, it has been estimated that approximately 80 per cent of fossil fuel reserves are needed to remain unextracted to put a brake on climate change - as reported in a Financial Times article titled 'Lex in depth: the $900bn cost of 'stranded energy assets'. Thus, a move in this direction - giving rise to a shrinking global market for oil, coal, and natural gas - is likely to create a long-term strain on the BoP of 'fossil-fuelled' economies, particularly in less-developed nations generally associated with the 'resource curse' (low export diversification).
CLIMATE INACTION IS NOT A SOLUTION: The looming climate crisis highlights the urgency to devise prudent and well-targeted policies to cushion the economy against such damaging and possibly irrevocable consequences. On the one hand, the adaptation approach, including the development of more climate-resilient agricultural strategies (i.e., crop and livestock diversification) and infrastructure, is vital to sustain vulnerable industries and foster food security. In terms of mitigation measures, carbon-taxing systems should be commensurable with the provision of public finance and subsidies (or development aid) for the adoption of cleaner production methods and technologies. Namely, climate policies should incentivise environmentally friendly companies to enhance their profitability and competitiveness (such as through the selling of carbon quotas that could, in turn, be invested in greater productive capacity). In both cases, developed countries play a pivotal role in assisting those less developed to adapt and mitigate promptly against climate change-induced risks. Consequently, these climate policies would help to ensure BoP stability - by driving export growth, as well as overall development and innovation, in the 'right', sustainable direction.
Chenlin Li and Chua Shu Yi are graduates of the School of Economics at the University of Nottingham in Malaysia. [email protected], [email protected]
