Climate transition spillovers and sovereign risk: Evidence from Indonesia

Abstract

We analyze the impacts of climate transition spillover risk on fiscal sustainability and sovereign risk in Indonesia. Spillover risk emerges from the introduction of energy decarbonization policies by Indonesia’s main trading partners, such as China. Spillover risk is modeled as a demand shock for Indonesia’s fossil fuels that affects its exports, building on the Network for Greening the Financial System’s scenarios. By tailoring the EIRIN Stock-Flow Consistent model, we quantify the impact of spillover risk on the Indonesian economy, on the sovereign fiscal and financial dimensions. We find that spillover risk weakens the Indonesian balance of payment, leading to indirect and cascading effects on public finance and public debt, which increases by up to 23 percent of GDP by 2050. Thus, potential trade-offs between energy decarbonization and sovereign financial stability could emerge, along with the materialization of carbon-stranded assets. Our results highlight the importance of coordinated climate policy introduction. They also bring out the importance to include spillover risks in the climate financial risk monitoring and assessment programs of national and international supervisory authorities (e.g. the Debt Sustainability Analyses and Financial Stability Assessment Programmes of the International Monetary Fund) for better risk management and climate policy design.