Nature loss is threatening debt sustainability

Biodiversity must be incorporated into debt sustainability assessments, write Moritz Kraemer, senior fellow, and Ulrich Volz, professor of economics and director, Centre for Sustainable Finance, SOAS, University of London.

Awareness of nature and biodiversity risks to the global economy is on the rise among investors and policy-makers. Financial authorities and markets are deepening their scrutiny of the link between environmental risks and economic and financial outcomes. Earlier this year, the Network for Greening the Financial System issued a statement on nature-related financial risks. It acknowledged that these risks, including those associated with biodiversity loss, could have significant macroeconomic implications, and that failure to account for, mitigate and adapt to these implications is a source of risks relevant for financial stability.

It is now critical that nature risks are properly integrated into macro-financial risk analysis in general, and debt sustainability analysis in particular. Just like climate change can amplify sovereign risk and drive up the cost of sovereign debt, nature loss can threaten a country’s debt sustainability. In a study published in July, we showed how sovereign debt sustainability can deteriorate significantly in a partial collapse of ecosystem services scenario. In a sister study, we modelled the impacts of nature loss on sovereign credit ratings.

Using novel World Bank estimates of the macroeconomic cost of a partial collapse of ecosystem services, we developed a four-step process for integrating nature-related risks into the debt sustainability framework for market access countries used by the International Monetary Fund. This methodology was applied to six countries – Bangladesh, Brazil, Canada, Indonesia, Nigeria and Vietnam.

The results show that nature loss matters for debt sustainability. For Bangladesh and Vietnam, the partial collapse of ecosystem services – relating to forestry and fisheries products, pollination and other services directly provided by nature – would eclipse all other stress scenarios in severity. This includes the IMF’s combined macro-fiscal stress scenario, in which the Fund lumps together individual macro shocks. For Indonesia and Nigeria, nature is the second-largest shock, after the combined IMF shock.

For Bangladesh – the country in the sample most affected by the partial nature collapse scenario – the debt-to-GDP ratio would rise by 15 percentage points to 56% within a year after the shock, compared to the baseline scenario without shock. In comparison, Bangladesh’s debt ratio increased by merely 4 percentage points between 2019-21 (to 40% from 36% of GDP). In other words, the nature collapse shock would be between three and four times as damaging to Bangladesh’s debt sustainability than even the pandemic has been. Similarly, gross financing needs would rise sharply when ecosystem services collapse as deficits rise, and GDP shrinks.

For Indonesia, a partial nature collapse would increase debt-to-GDP ratio by over 11 percentage points to exceed 63%. GDP would shrink by 11%, which is almost 4 percentage points more than the pandemic caused. Brazil would see an increase in the debt-to-GDP ratio of 7 percentage points while its GDP would fall by over 4% in the case of a partial nature collapse. Nigeria’s debt-to-GDP ratio would grow by over 13 percentage points and GDP decrease by 9.5%.

Without considering nature-related risks, the IMF’s DSAs will for many countries misdiagnose the true risks to debt sustainability, leading to erroneous policy recommendations and increasing the risk of avoidable debt crises.

The debt sustainability assessment resulting from the Fund’s DSAs has important consequences. The DSA classification may have repercussions for governments’ market access or the need to outright restructure public sector obligations. It powerfully drives the macro-conditionality of IMF-sponsored economic programmes.

It is therefore imperative that the IMF and World Bank introduce biodiversity and natural capital risks into their DSAs and other analytical frameworks for macroeconomic and financial risk analysis. By developing a global macroeconomic model that is linked to science-driven environmental economic models of ecosystem service provision, the World Bank has laid the groundwork for incorporating scenarios for the macroeconomic consequences of nature loss into DSAs. Given the significance of nature-related risks for economic prosperity and development, failing to integrate nature-related risks into DSAs and other macroeconomic and financial risk assessments would be a grave omission.