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ABSTRACT
Foreign direct investment (FDI) inflows are considered to be an important source of private financing for several emerging markets and developing economies (EMDEs). However, the high susceptibility of these countries to climate change impacts vis-à-vis their developed counterparts may reduce their attractiveness as a favourable destination for FDI inflows. EMDEs with significant exposure to physical climate risks present a higher incidence of financial risks for foreign investors, which may in turn discourage them from locating themselves in such jurisdictions where their profitability and operations could be jeopardized by climate disasters. Given this context, we empirically investigate how physical climate risks influence FDI inflows to 68 EMDEs using data from over two decades, from 1995 to 2017. We contribute to an emerging body of literature that assesses the impact of climate risks on macro-financial variables by focusing specifically on FDI inflows. Although we abstain from making strong causal claims in our paper, we account for endogeneity concerns extensively and our empirical results show that higher climate risks adversely impact FDI inflows to EMDEs. However, we find these negative effects can be mitigated to a significant degree by strengthening financial sector development in the host country, as it increases their capacity to absorb some of these climate risks more effectively.
Key policy insights
Emerging markets and developing economies (EMDEs) that are more vulnerable and exposed to physical climate risks tend to be less attractive destinations for FDI inflows.
Negative effects of physical climate risks on FDI inflows tend to be mitigated in EMDEs with a high degree of financial development.
Well-developed, deep, and inclusive financial markets give EMDEs the capacity to absorb and manage various financial risks including those arising from climate change impacts.
Acknowledgements
We would like to express our gratitude to the editor and three anonymous reviewers for their highly constructive suggestions that helped us markedly to improve the quality of our paper. The lead author would also like to acknowledge the valuable inputs and guidance received from his colleague Dr. Usman Khalid in determining the contribution of the effective sample weights based on one of the reviewer’s recommendations.
Disclosure statement
No potential conflict of interest was reported by the author(s).
Notes
1 Our conceptual use of ‘climate risks’ in this paper is based on existing studies which describe the ways in which climate change could impact financial stability. This literature considers climate risks as a kind of business risk for firms. However, we appreciate that the nature of climate risk is quite different from other business risks posed to firms. While the latter can often be quantified, climate risks are rather difficult to quantify largely because the impacts of climate change are still challenging to map/predict and there exists no historical precedent upon which these can be based. Since the quantification of climate risks is still at a rudimentary stage, the concept of climate risk resembles more an approximated uncertainty than a probability-based risk measure (Reisinger et al., Citation2020). We would like to thank an anonymous reviewer for raising this point/issue.
2 This is done using data from the IMF Climate Change Indicators Dashboard, which captures the mean value of changes in surface temperatures during 1961–2021 using temperatures persisting between 1951 and 1980 as the baseline.
3 Available at: https://gain.nd.edu/our-work/country-index/.
4 The overall index score of a country is determined by the level of exposure and sensitivity of six crucial life-supporting sectors to extreme weather events (‘gross vulnerability to climate change’) minus the economic, governance, and institutional capacity of the country (‘readiness’) to mobilize resources and engage in climate change mitigation and adaptation initiatives.
5 Data on gross FDI is available from https://unctadstat.unctad.org/wds/TableViewer/tableView.aspx.
6 We also present a simple scatterplot capturing the correlation between FDI inflows and the vulnerability index of all countries in our panel sample in Figure A4.1. The figure suggests that climate risks and FDI are negatively correlated.
7 Data on economic policy uncertainty is available from https://www.policyuncertainty.com/.
8 Following a suggestion from an anonymous reviewer, we also determine the effective weights of the countries in our sample that contribute to the variation in climate risks which are instrumental behind driving our benchmark results. The results are in the Supplementary Materials, Annex Table A1.3.
9 We acknowledge that financial development in the home country could be a significant factor in mediating FDI inflows to the host country. A closer examination of this issue, however, requires bilateral data on FDI flows between the sending (home) and host country but we currently lack these data.
10 However, we do not yet have extensive data on green financial policies per se to delineate their direct impact in mitigating climate risks to FDI inflows in EMDEs.
11 Data on these indicators are available from the IMF Financial Development Index Database, accessible from: https://data.imf.org/?sk=F8032E80-B36C-43B1-AC26-493C5B1CD33B.