Climate transition spillovers and sovereign risk: Evidence from Indonesia

Abstract

We study the macro-financial relevance of climate transition risks for sovereigns that can materialize as a result of the introduction of low-carbon policies in a trading partner country. We define this notion as climate transition spillover risk, and we apply it to the analysis of the introduction of carbon pricing in China on Indonesia, a major coal producer and exporter to China. By tailoring the EIRIN Stock-Flow Consistent model, we quantify the impact of a shock on Chinese demand for Indonesian coal, consistently with the scenarios of the Network for Greening the Financial System, on the Indonesian economic performance, fiscal and financial risk. We find that transition spillover risk directly weakens the Indonesian balance of payment, which decreases by 4.4 percent of GDP, leading to indirect and cascading effects on public finance and public debt, which increases up to 9.6 percent of GDP. Further, we find a trade-off between trade decarbonization and sovereign financial stability for Indonesia, resulting in carbon-stranded assets. Our results highlight the importance for supervisory institutions, such as the International Monetary Fund, to integrate climate spillover transition risk in their debt sustainability analyses and financial stability assessment programs.

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