The Potential Impact of El Niño on Sovereign Debt
Key findings
- The likelihood of an El Niño event forming by the end of 2023 has increased to over 95%. Such an occurrence could cause suboptimal weather, leading to lower yields and rising prices for staple food crops.
- Our research indicates that the debt-to-GDP ratio for global sovereigns, especially in emerging markets, tends to deteriorate during the year following El Niño due to lower economic growth and higher government spending.
- Comparing physical-risk and financial-governance scores could help investors identify which sovereign issuers may be more susceptible to El Niño-related climate risks and the debt stresses they may face.
There is now a 95% probability that we will see an El Niño event during the 2023-2024 winter in the northern hemisphere, with forecasters anticipating it to be "strong."[1] Typical El Niño effects include suppressed rainfall across Southeast Asia from December to February and dry/warm weather across large swaths of South America from June to August.
El Niño's negative impact on key crop yields
Agriculture is one of the main sectors of the economy that could be severely affected by El Niño. Maize in China, East and West Africa, Mexico and Indonesia; rice in southern China, Myanmar and Tanzania; and wheat in parts of China have all been negatively affected by recent El Niño episodes, while global average yields for rice (-1.3%), corn (-0.3%) and wheat (-4.0%) tend to be below normal during El Niño years.[2] Indeed, benchmark rice prices in Asia already rose to a near-15-year record in mid-August 2023 due to concerns that El Niño-related dryness could reduce production in Thailand (the world's second-largest exporter).[3]
Public-debt ratios may start to deteriorate in 2024
Higher food prices, already elevated from the COVID-19 supply-chain shock and the Russia-Ukraine war, could be the start of a cascading trend for the global economy. Governments may increase relief spending to provide a safety net for citizens. Depending on the magnitude of impact, countries may need to ratchet up capital expenditure to repair damaged infrastructure.[4] Productivity could also worsen, reducing economic output.[5] Some areas, such as Peru and Southeast Asia, have already begun to prepare for El Niño.[6]
The combination of lower economic growth and higher fiscal expenditure could result in higher public-debt-to-GDP ratios for impacted sovereign issuers. MSCI determined that the median debt-to-GDP increase for the years following an El Niño event was 0.6% of GDP globally and 2.1% for emerging markets (based on data between 1994 and 2021). Although there seems to be a statistically significant relationship between El Niño and a country's debt-to-GDP ratio[7] — even when controlling for variables such as the primary budget balance, GDP growth and exchange-rate fluctuations — we acknowledge that two of these periods took place during other major financial events: the Asian financial crisis and COVID-19.[8] Given the limitations of the historical analysis, we are curious to see whether developments during this period support our hypothesis that debt-to-GDP ratios rise in the year after an El Niño event.
Debt-to-GDP ratios tend to increase the year after El Niño
Annual data from 1995-2021. Data from 59 countries for global sample, 32 for emerging-market sample. Plot with boxes and whiskers shows the median change in debt-to-GDP which occurred during the year after El Niño events versus not. The top of the box corresponds to the 75th percentile of the data, while the bottom corresponds to the 25th percentile of the data. Individual dots above or below the box are outliers. Countries selected if all data was available to run the regression analysis described in the footnotes. Source: MSCI ESG Research, International Monetary Fund, National Oceanic and Atmospheric Administration
Governments' financial position and physical-risk vulnerability could signal the most at-risk sovereign issuers
Sovereign-debt investors may wish to bear El Niño in mind when making country-allocation decisions. El Niño tends to negatively affect issuers in South America, Southeast Asia and parts of Sub-Saharan Africa more than regions in the northern hemisphere. However, the magnitude and nature of the impact can vary substantially between countries[9] and even within countries.[10]
The current baseline of a sovereign issuer's credit fundamentals and physical-risk exposure and management is also important. Within MSCI ESG Government Ratings, investors may wish to compare the country's financial-governance and physical-risk scores to assess existing vulnerabilities. For both scores, a low number means that a country possesses high risk exposure and poor management of those risks.
Comparing these two scores illustrates that if a country is already in a strained financial position and generally possesses high levels of physical risk, an extreme El Niño event could exacerbate its ability to service debt.
Countries with low financial-governance and physical-risk scores may be more susceptible to El Niño
"El Niño impacted" is defined as countries whose region is South America, East Asia or South Asia, per MSCI ESG Research's methodology. This is a stylized and non-exhaustive sample of countries that may be affected by El Niño. Data as of Aug. 10, 2023. Source: MSCI ESG Research
Our research highlights that the governments of certain countries that score poorly on both factors may not be able to fully provide financial relief to the economy, resulting in "loss and damage." Impact investors, bilateral lenders and multinational development banks may need to mobilize financing during this El Niño event to avoid loss-and-damage outcomes.
1 El Niño and La Niña are two phases of a naturally occurring large-scale climate phenomenon and result from periodic warming or cooling, respectively, across the central and east-central equatorial Pacific Ocean. El Niño refers to the warming phase. A strong El Niño does not necessarily equate to strong El Niño impacts locally, as the likelihood of related climate impacts can be lower than the chances of El Niño itself. “El Niño/Southern Oscillation (ENSO) Diagnostic Discussion.” Climate Prediction Center, Aug. 10, 20232 Toshichika Iizumi, et al. “Impacts of El Niño Southern Oscillation on the global yields of major crops.” Nature Communications 5, 3712 (2014).3 Anuradha Raghu. “Rice Soars to Highest Since 2008 on Rising Threats to Supply,” Bloomberg, Aug. 9, 2023.4 Joe Daniels, et al. “South America braced for economic hit from return of El Niño.” Financial Times, Jul. 31, 2023. This article notes that Peru spent around USD 8 billion in fiscal stimulus packages after the 2014-2016 El Niño cycle.5 Christopher W. Callahan and Justin S. Mankin. “Persistent effect of El Niño on global economic growth.” Science. Jun. 9, 2023.6 Marco Aquino. “Peru to spend more than $1 bln on climate plan, mitigate El Niño.” Reuters, Mar. 23, 2023.
Erwida Maulia, Apornrath Phoonphongphiphat, and Lien Hoang. “South-east Asia braced for fires and drought brought on by El Niño.” Financial Times, Jun. 28, 2023.7 Using data from the International Monetary Fund, Bank for International Settlements and National Oceanic and Atmospheric Administration, MSCI ESG Research ran a panel regression analysis with fixed effects for 59 countries globally over 27 time periods, as well as a separate panel regression for 26 countries over 27 time periods for emerging markets. The results showed statistically significant t-stats for all three independent variables used: a dummy variable showing whether an El Niño event took place one year prior; the primary budget balance; and a combination of growth, inflation and exchange-rate factors. The R-squared for both regressions were around 0.3. Null hypotheses of the regressions containing heteroskedasticity, serial correlation and multicollinearity were all rejected at the 5% significance level.8 There have been four El Niño events during the period of our analysis: 1997, 2015-2016 and 2019. Note that MSCI uses the lagged El Niño dummy variable (0 or 1) for this analysis, meaning that the years when debt-to-GDP was impacted were 1998, 2016-2017, and 2020. It's worth acknowledging that two of these four periods corresponded with global financial events: the Asian financial crisis in 1997-1999 and the start of COVID-19 in 2020. While these likely affected the results, we still hypothesize that the lower growth and higher fiscal outlays that accompany El Niño periods have an impact on a country's debt/GDP. For example, Peru's debt/GDP increased by about 3% between 2016 and 2018 and Indonesia's debt-to-GDP by approximately the same amount. A shortcoming of this analysis is that there is not enough macroeconomic data to consider El Niño events before the 1990s. Many emerging-market countries did not have credible and thorough data before then, and European data is complicated during the Cold War.9 Daniels et al. suggest that Argentina and Uruguay, for example, often have bumper-crop yields during El Niño years, but that is not a guarantee.10 Wenji Cai, et al. “Climate impacts of the El Niño–Southern Oscillation on South America.” Nature Reviews Earth & Environment, April 2020.
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