A call to reinvent the IMF: Tackling climate change?

Global - Jun 27 2019
  • #credit risk
  • #esg

A call to reinvent the IMF: Tackling climate change?

In the last issue of its magazine “Finance & Development” (June 2019) dedicated to its 75th anniversary, the International Monetary Fund (IMF) reviews its recent history and -with the help of external contributors- tries to imagine its place in the coming world. Adam Tooze, in an article entitled “Reimagining the IMF”[1], recalls that in 2007, the economist Barry Eichengreen called the Fund a “rudderless ship adrift in a sea of liquidity”, while Mervyn King, then governor of the Bank of England warned that it was at risk of “slipping into obscurity”. At that time, “its outstanding loans had shrunk to about 11.1 billion USD” wrote Adam Tooze. However, the Global Financial Crisis and the European Sovereign Debt Crisis relaunched the need for the lender of last resort. That notwithstanding, “in the post-crisis world, the Fund must move beyond its role as lender of last resort “.

Given the huge challenge facing mankind in the following decades with climate change, it would be logical for the Fund to have a key role to play. This seems confirmed by the IMF’s Managing Director’s Statement on Environment (2015)[2], arguing that “the Fund has a role to play in helping its members address those challenges of climate change for which fiscal and macroeconomic policies are important component of the appropriate policy response”. In this Insight, we will thus explain why climate change will directly have a macroeconomic impact and therefore should be taken into account as an important part of the Fund’s traditional Debt Sustainability Reports (Article IV), then we will discuss the current’s IMF approach of climate change.

  1. Why should Assessing Climate Change Impact be part of a Debt Solvency Assessment?

In the economic theory, the 1980’s American concept of Laffer Curve limits the government’s ability to raise revenues, as tax distortions discourage economic activity, thereby creating an upper bound on government revenues. Figure 1 helps to understand the concept of the Laffer curve: there is a peaking point corresponding to a tax rate above which fiscal revenue are lower due to the distortionary effect on the economic activity. We refer to this upper limit as a fiscal limit.

Figure 1: Laffer curve, “Fiscal Sustainability: A Cross-Country Analysis”, by Huixin Bi, 2017[3]

On the spending side, economies require some minimum level of government expenditures to function, which effectively put a floor on spending. These considerations imply that fiscal surpluses (difference between tax revenues and government expenditures) thus face a maximum ceiling. This maximum fiscal surplus is at the basis of the definition of the solvency ratio, expressed in terms of debt-to-GDP ratio (Bi 2012[4], Guillard and Kempf 2017[5]):

The solvency ratio  is determined by the discounted sum of maximum future government surpluses. Given economic conditions,  is the maximum tax revenues a government can collect. Government spending are . The further the discount factor  is below 1, the more investors discount future fiscal surpluses.

According to this framework, countries have different solvency ratio due to heterogenous fiscal limits, fiscal policy and investors preferences. These maximum future surpluses and discount factors depend themselves on future economic and policy conditions. As highlighted by Figure 1, an economic boom (represented in the model as a productivity shift upwards) will raise the maximum tax revenues a government could collect, while a recession (represented in the model as a productivity shift downwards) will reduce them. Any such shift will therefore directly impact the solvency.

This framework can intuitively help to understand why climate change will impact countries’ solvency and should be an integrated part of the IMF’s debt assessment.

Indeed, climate physical risks will impact maximum tax revenues through (not exhaustively): (i) temperature increase impact on productivity (Burke et al. 2015[6]); (ii) increasingly frequent natural disasters-related shocks on economic output (Hsiang and Jina, 2017[7]). Furthermore, natural disasters could weigh on government spending, as governments are generally involved in the reconstruction investment process. Thus, climate change impact will act as a shock on productivity: the higher temperature will affect productivity downwards and then reduce maximum fiscal surpluses, which in turn will reduce the solvency ratio.

  1. The current IMF’s approach of Climate Change: Work in Progress

The IMF has not been unaware of climate change impact on fiscal conditions. For example, Bonen et al. (2016[8]), in an IMF Working Paper, proposed a macroeconomic model to assess the increasing level of climate risks faced by developing countries and determined an optimal path of climate change adaptation and emissions mitigation. Kireyev (2018[9]), also in an IMF Working Paper reviewed the macro-fiscal impact caused by climate change in Djibouti, associating costs of migration and determining optimal adaptation policies. More interestingly, the IMF launched a country’s report series in 2017: “Climate Change Policy Assessment”. In this report (distinct from the Debt Sustainability Assessment Report, called “Article IV”), the Fund reviews: (i) the climate change risks and expected impacts; (ii) the contribution to Mitigation; (iii) the adaptation plans; and (iv) the financing strategy for mitigation and adaptation programs.

However, this “Climate Change Policy Assessment” is available only for Belize, St Lucia and the Seychelles, countries that are yet more exposed to physical risks than others.

As these countries have a low overall and marginal contribution to climate change, the emphasis on climate mitigation actions for low-income countries and small states is insufficient but it is still a first step.

Given (i) the direct potential impact of climate risks on debt solvency and (ii) the insignificance of their contribution to climate change for countries thus far covered by the “Climate Change Policy Assessment”, a way to reinvent the IMF could be to frontally tackle climate change. This would materialize through a two-pronged approach: (i) implement systematically a climate change policy assessment within the Article IV reports (“Debt Sustainability Assessment Report”), given the high importance is given to it by finance ministers; (ii) (and this is directly linked to the first proposal) extend the climate change policy assessment to all countries covered by Article IV, rather than limit it to a few countries only.

This could be implemented without any new mandate, as it is fully integrated within its current mandate of the lender as last resort. Besides, it would have large positive impacts in terms of climate risks stocktaking by governments.

Thomas Lorans, Economist
Sources: Beyond Ratings

 

[1] https://www.imf.org/external/pubs/ft/fandd/2019/06/pdf/reimagining-the-imf-tooze.pdf

[2] https://www.imf.org/en/Publications/Policy-Papers/Issues/2016/12/31/The-Managing-Directors-Statement-on-the-Role-of-the-Fund-in-Addressing-Climate-Change-PP4998

[3] Bi, H. (2017). Fiscal Sustainability: A Cross-Country Analysis. Economic Review, (Q IV), 5-35.

[4] Bi, H. (2012). Sovereign default risk premia, fiscal limits, and fiscal policy. European Economic Review, 56(3), 389-410.

[5] Guillard, M., & Kempf, H. (2017). Public Debt Sustainability and Defaults.

[6] Burke, M., Hsiang, S. M., & Miguel, E. (2015). Global non-linear effect of temperature on economic production. Nature, 527(7577), 235.

[7] Hsiang, S. M., & Jina, A. S. (2014). The causal effect of environmental catastrophe on long-run economic growth: Evidence from 6,700 cyclones (No. w20352). National Bureau of Economic Research.

[8] Bonen, A., Loungani, M. P., Semmler, W., & Koch, S. (2016). Investing to mitigate and adapt to climate change: a framework model. International Monetary Fund.

[9] Kireyev, M. A. P. (2018). Macro-Fiscal Implications of Climate Change: The Case of Djibouti. International Monetary Fund.

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