When Does Water Scarcity Become a Sovereign Financial Risk? International Threshold Evidence on Sovereign Borrowing Costs

Water scarcity is increasingly recognized as a macroeconomic challenge, yet its implications for sovereign financing conditions remain insufficiently understood. This study examines whether water scarcity is associated with sovereign borrowing costs and whether this relationship strengthens once hydrological pressure exceeds a critical threshold. Using an international panel of 105 countries over the period 2000–2024, the analysis combines second-generation panel diagnostics with nonlinear threshold estimation to examine long-run relationships and regime-dependent effects. The results indicate that water scarcity is positively associated with sovereign risk premiums, but the relationship is distinctly nonlinear. A critical threshold is identified at 61.37% water stress, beyond which the estimated association becomes substantially larger, with the coefficient increasing from 0.005 below the threshold to 0.024 above it. This pattern suggests that severe hydrological pressure is more strongly associated with higher sovereign borrowing costs than moderate water stress. The analysis further suggests that financial development, renewable energy deployment, and stronger institutional quality are associated with a weaker relationship between water scarcity and sovereign risk premiums, highlighting the potential importance of domestic resilience capacity. These findings remain broadly robust across alternative sovereign risk measures, alternative water scarcity proxies, dynamic specifications, and smooth-transition nonlinear models. This study contributes to the emerging literature on environmental macro-financial linkages by providing evidence that water scarcity may be increasingly relevant for sovereign financing conditions, particularly in economies facing severe and persistent hydrological stress.