UAEU researcher in collaboration with National University of Singapore examined the influence of climate risks on foreign direct investment inflows to emerging and developing economies

Climate change is associated with a rise in global temperatures and an increased incidence of extreme-weather events, such as floods and droughts, and thus portends huge economic losses for countries worldwide. The economic impact of climate change is gradually gaining prominence in policy circles, especially in emerging markets and developing economies (EMDEs), motivated in part by the rise in frequency and severity of extreme-weather events in recent years. Given the high susceptibility of EMDEs to climate change, to what extent will their exposure to physical climate risks influence foreign direct investment (FDI) inflows to these countries?

Foreign direct investment (FDI) inflows are considered to be an important source of private financing for several EMDEs. However, their high vulnerability to the adverse impacts of climate change 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, it becomes an important policy question to understand if and how physical climate risks influence FDI inflows to EMDEs. This project uses data for 68 EMDEs from over two decades, from 1995 to 2017 to empirically assess the influence of physical climate risks on gross FDI inflows to EMDEs. It contributes to an emerging body of literature that assesses the impact of climate risks on macro-financial variables by focusing specifically on FDI inflows.

The key hypothesis that the paper advances and tests is that a higher susceptibility to physical climate risks adversely impacts the magnitude of FDI inflows for EMDEs. This could occur as higher exposure to climate risks renders firms more vulnerable to the after-effects of extreme-weather events and the gradual effects of sea-level rise. This, in turn, adversely impacts their financial health, exacerbates business risks, and counteracts the potentially higher benefits from investing in EMDEs (in terms of costs and market potential). On balance, whether the higher economic benefits accruing to firms from investing in EMDEs are counteracted by the greater vulnerability of these countries to climate change is an empirical issue which the paper tests for.

The empirical results, after accounting for endogeneity concerns extensively, show that higher climate risks adversely impact FDI inflows to EMDEs. However, the results also indicate that 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. Thus, countries vulnerable to climate change should adopt strategies to enhance financial inclusion and undertake deepening of financial markets to address the adverse effects of physical climate change risks on foreign investment. This will enable them to retain their status as attractive destinations for inward FDI and also help raise private financing to better mitigate climate risks.

The research is conducted by Dr, Sasidaran Gopalan, Assistant Professor, Department of Economics and Finance, College of Business and Economics, in collaboration with Prof. Ramkishen S. Rajan and Bhavya Gupta (PhD student) from National University of Singapore.

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To read more about the research: https://www.tandfonline.com/doi/full/10.1080/14693062.2023.2237479