A climate-augmented fiscal reaction function approach to modelling debt sustainability in EMDEs

Purpose This study examines how comprehensive climate risk, beyond acute physical risks, affects fiscal sustainability in emerging markets and developing economies (EMDEs). It addresses a critical gap in the literature by exploring how both physical and transition risks shape fiscal policy responses and influence the interaction between primary balances and public debt. Design/methodology/approach We augment the standard Bohn fiscal reaction function with the Notre Dame Global Adaptation Initiative (ND-GAIN) index and its subcomponents of readiness and vulnerability. Using system GMM estimation on a balanced panel of 120 EMDEs over the period 2001 to 2022, we evaluate both linear and nonlinear fiscal responses. Threshold and curvature effects are introduced to capture heterogeneity across varying levels of climate risk exposure. Findings Climate vulnerability has a significant adverse effect on fiscal balances, with a 0.1 point increase in vulnerability reducing the primary balance by 1.29 percentage points. Countries with above median climate resilience exhibit primary balances that are 2.27 percentage points higher than those of less resilient economies. Inverted U-shaped fiscal responses suggest that fiscal effort declines beyond certain resilience thresholds, reflecting a tradeoff between improved capacity and policy complacency. Originality/value This study is the first to incorporate a comprehensive measure of climate risk, including transition risks, into the fiscal reaction function framework. By uncovering both linear and nonlinear responses, it offers novel insights into how climate resilience influences debt sustainability and highlights the importance of climate aware fiscal strategies in EMDEs.