Impact of climate vulnerability on fiscal risk: Do religious tensions and financial development matter?

Using data from around 100 countries between 1995 and 2019, we examine the impact of climate vulnerability on fiscal risk. We also explore the transmission channels that are important for the relationship between climate vulnerability and fiscal risk. Our results show that in highly climate-vulnerable economies, increased vulnerability leads to higher government bond yields by 0.5 to 1.5 percentage point and lower sovereign debt ratings by up to one notch over two years. These effects are exacerbated by religious tensions as a form of political instability but mitigated by well-developed financial markets. Therefore, even though fiscal consolidation is crucial for containing fiscal risks in the case of climate vulnerability, political stability and financial development also matter. • Climate vulnerability raises sovereign bond yields and lowers ratings. • Fiscal effects are stronger in politically unstable environments. • Developed financial institutions mitigate climate-related fiscal pressures. • Religious tensions is a major driver of climate-risk premiums. • Institutions and finance shape fiscal resilience to climate shocks.