Macroeconomic and Fiscal Consequences of Climate Change in Latin America and the Caribbean

1 Introduction

Climate change represents a growing threat to Latin America and the Caribbean. The region is highly vulnerable to changes in hydrometeorological conditions and rising temperatures threaten to undercut long-term economic growth by reducing labor productivity, decreasing agricultural production, and contributing to a rapid depreciation of the capital stock (Alatorre and Fernández Sepúlveda 2022; IMF 2021a; Ranasinghe et al. 2021). Existing estimates in the literature suggest that the macroeconomic losses due to climate change in the region could be significant (Burke, Hsiang, and Miguel 2015; Kahn et al. 2019; Swiss Re Institute 2021; Van der Borght, Samaniego, and Galindo 2023).

Agricultural production in the region is already under significant climate-induced stress. Yields for key staple crops are in decline and are projected to fall further by midcentury (Castellanos et al. 2022; Romanello et al. 2021). Countries along the dry corridor in Central America are particularly vulnerable to these trends due to widescale subsistence farming carried out by predominantly poor rural populations (Baca et al. 2014; Bouroncle et al. 2017). Lower agricultural yields will intensify food insecurity and create greater pressure for domestic and international migration (Läderach et al. 2021; Linke et al. 2023; WMO 2022).

The increasing frequency and severity of extreme climatic events are exacting a growing toll on the region (Bloemendaal et al. 2022; Bhatia et al. 2020). The 2020 tropical cyclone season was emblematic of this trend with Hurricanes Eta and Iota causing widespread destruction. In Honduras, these storms caused damage equivalent to 8.9 % of GDP and impacted an estimated 45 % of the population (BID-CEPAL 2021). In the Caribbean, tropical cyclones cause upwards of 5.7 % of GDP in damage to the capital stock per year (Acevedo 2016). The intensification of climate change is projected to significantly disrupt tourism in the Caribbean (Cevik and Ghazanchyan 2020; Granvorka and Strobl 2013; Pathak et al. 2021).

Investment to respond to climate change is currently lacking. The region invests little in absolute terms and relative to other developing regions (Titelman et al. 2023). Public investment is particularly weak, resulting in a public capital stock vulnerable to climate change and unable to provide the economic services needed for growth (ECLAC 2022). Fiscal space to increase public investment is limited. Public debt levels are at levels not seen in the last 20 years (ECLAC 2023a). Countries are under increasing pressure to cut spending to ensure debt sustainability.

Responding to climate change is an economic and social imperative for the region. To assess the potential macrofiscal impact of climate change in Latin America and the Caribbean we examine six country cases: Barbados, Dominican Republic, El Salvador, Guatemala, Honduras, and Saint Lucia (CAC6). Members of this group are uniquely vulnerable to changes in climatic conditions due to their geography, their elevated dependence on economic activities that will be heavily impacted by climate change (such as agriculture and tourism), and their differing levels of poverty and inequality.^[1]

This article contributes to the existing literature in several ways. First, it provides additional estimates for the macroeconomic damage caused by lower productivity and more destructive and severe weather events in Central America and the Caribbean. It also presents an independent measure of the investment needed to combat climate change. Second, this article explores the macrofiscal implications of an investment strategy based on the investment requirements outlined in the Nationally Determined Contributions (NDCs). Third, we establish the important role that concessional climate finance could play to make an NDCs-based investment push viable.

The remainder of this article is organized as follows. Section 2 reviews investment trends and fiscal constraints for additional public climate investment. Section 3 describes the methodology used to model climate shocks and provides results. Section 4 presents the estimates of the macrofiscal implications of an NDCs investment strategy, while Section 5 examines concessional climate finance and debt dynamics. Finally, Section 6 provides concluding remarks.

2 Large-Scale Investment is Needed to Combat Climate Change, but There are Significant Fiscal Constraints to an Increase in Public Investment

These results are broadly in line with estimates in the literature of the magnitude of investment necessary to achieve sustainable development objectives. Bhattacharya et al. (2022) finds that emerging markets, excluding China, would need to raise their spending on human capital, sustainable infrastructure, adaptation and resilience, and restore natural capital from 11.3 % of GDP in 2019 to 18.2 % of GDP in 2030 to meet key development and climate goals. Similarly, Rozenberg and Fay (2019) estimate that annual investment outlays of 7.2 % of GDP would be necessary in low- and middle-income countries to close development gaps in electricity, transportation, water sanitation, flood protection and irrigation.

Estimates for Latin America and the Caribbean are sparse, but they are in line with investment requirements for emerging and developing economies. For example, Rozenberg and Fay (2019) find that the region would require annual investment outlays of between 2.6 % of GDP and 8.8 % of GDP. Fay et al. (2017) provides a similar range of estimates for additional annual infrastructure investment, with figures from 3 % of GDP to 8 % of GDP. These estimates for the region are focused principally on closing infrastructure gaps. Including social goals would potentially result in much larger spending demands. For example, Castellani et al. (2019) find that countries in the region would need to spend upwards of 10.6 % of GDP per year by 2030 to address infrastructure needs and to tackle extreme poverty.

These requirements contrast sharply with investment trends in CAC6 countries. Total gross fixed capital formation during the period 2010–2019 fell relative to 2000–2009 in all countries except the Dominican Republic (Table 1). The contraction in total investment in 2010–2019 was not shared equally across CAC6 countries. Significant declines were registered in Guatemala (−3.8 percentage points of GDP), Honduras (−2.8 p.p. of GDP), Saint Lucia (−2.5 p.p. of GDP) and Barbados (−2.4 p.p. of GDP). In contrast, investment was relatively stable in the Dominican Republic. Falling public investment was the principal driver of the reduction in total investment in several countries. This coincided with efforts over the period to constrain public spending with the aim of ensuring public debt sustainability.

Fiscal space to undertake climate change investment is limited. In the decade between 2010 and 2019, general government gross public debt rose sharply in most of the CAC6 countries: Barbados (14.8 p.p. of GDP), Dominican Republic (16.3 p.p. of GDP), El Salvador (11.3 p.p. of GDP), Honduras (21.2 p.p. of GDP), and Saint Lucia (9.9 p.p. of GDP) (Figure 1). In the case of Barbados, this variation hides significant volatility in the level of public debt, which rose to 158.3 % of GDP in 2017, before a comprehensive restructuring in 2018–2019 substantially reduced the debt burden. Guatemala was the only country where debt levels remained relatively stable over the period, which reflects a tight fiscal stance. The COVID-19 crisis created a generalized and significant increase in public debt levels. The most prominent increases between 2019 and 2020 were registered in Saint Lucia at 34.8 percentage points of GDP followed by El Salvador (18.1 p.p.), Dominican Republic (17.9 p.p.), and Barbados (16.8 p.p.).

Figure 1:

CAC6: general government gross public debt, 2000–2022. (Percentages of GDP). Source: Author’s elaboration based on IMF (2023).

Spending pressures and slowing public revenues notwithstanding, public debt trajectories for most of the CAC6 countries are currently considered sustainable by the IMF. Estimates in recent Article IV staff reports based on the Debt Sustainability Analysis (DSA) framework find that debt dynamics in Barbados, Dominican Republic, Guatemala, Honduras, and Saint Lucia are consistent with stable or declining debt levels (IMF 2022b, 2022c, 2022d, 2022e, 2021b). Only in El Salvador are current debt dynamics considered to be unsustainable (IMF 2022f). However, traditional measures of debt sustainability do not sufficiently capture the development implications of high levels of debt service (ECLAC 2023b).

As highlighted in ECLAC (2023b), interest payments by members of the group are very significant. CAC6 countries dedicate between 14 % and 24 % of their tax revenues to cover interest payments, with the highest levels observed in the Dominican Republic and El Salvador. At the same time, interest payments in Barbados, Dominican Republic, El Salvador, and Honduras equaled to nearly 100 % or more of central government capital expenditures, which served as the principal instrument of fiscal adjustment during the last decade. Interest payments represent roughly one-third of central government social spending in Dominican Republic, El Salvador, and Honduras.

3 Climate Change Shocks Will Negatively Impact Medium-Term Growth

The economic impact of climate change in CAC6 countries is multifold and is not easily modelled. Following Central Bank of Chile (2017) and IMF (2022a), a trend growth baseline scenario for 2025–2050 is estimated by employing a neoclassical Cobb-Douglas production function with constant returns to scale (Annex 1). A scenario capturing the intensification of climate change shocks is constructed by incorporating their effect through two principal channels. First, the model incorporates forecasts prepared by the Network for Greening the Financial System (NGFS) of economic losses from the progressive reduction in labor productivity and agricultural production (NGFS 2021). Second, the model incorporates losses due to increasingly severe extreme weather events. This is simulated in the model using a series of progressively larger natural disasters occurring in five-year intervals across the forecast period. These events impact economic growth through their destructive impact on capital stock.

The simulated economic consequences of the intensification of climate shocks for CAC6 countries are significant, with a significant decline in both rate of growth and level of per capita GDP over the medium term relative to the trend growth counterfactual (Table 2). The shortfall in growth reflects the progressive and stepwise drag on labor and agricultural productivity caused by rising temperatures. These effects are especially acute in countries such as El Salvador, Guatemala and Honduras, where the agricultural sector and related activities represent a significant share of economic activity. At the same time, all CAC6 countries will be exposed to an increase in severe weather events – droughts, floods, and hurricanes, among others – that will have a destructive impact on the capital stock and therefore on economic growth. These effects would be tempered by the continued, albeit decelerating, growth of the labor force in countries such as the Dominican Republic, El Salvador, Guatemala and Honduras.

The negative impact of climate shocks is also reflected in the trajectory of GDP per capita, which in most CAC6 countries would continue to grow but at a lower rate than compared to the trend growth scenario counterfactual. This is particularly concerning for the countries of Central America and the Dominican Republic with relatively lower levels of GDP per capita; their populations are projected to undergo a rapid demographic transition, suggesting that climate change will make attaining higher middle-income status more difficult before they grow older. These countries already face relatively higher levels of multidimensional poverty – income, education, health, and basic infrastructure – which will be further aggravated by these trends.

Compensating for the economic losses caused by climate change would require an unprecedented and sustained investment push. Based on the results of the macroeconomic modelling, returning to the level of per capita GDP estimated in 2050 under the trend growth scenario from the intensification of climate shocks scenario could be possible, but it would necessitate on average additional annual investment exceeding 5 percentage points of GDP in Dominican Republic (5.8), El Salvador (5.3), Guatemala (5.3), and Saint Lucia (6.9), and more than 8 percentage points of GDP in Barbados (8.5) and Honduras (10.9).

These investments would need to be economy-wide, driving a productive transformation that would generate sustainable economic growth. It is important to note that these estimated annual values do not consider potential inefficiencies in the implementation of investment projects or the existence of structural limits to additional investment. Therefore, policymakers seeking to compensate for the losses due to climate change should also consider investments in other areas such as research and development, education and training, and health, to bolster total factor productivity.

These results should be considered with care, acknowledging the inherent limitations of Cobb-Douglas modelling approaches. For example, the assumption of homogenous elasticity of substitution between labor and capital is especially problematic as climate change will have a strong sectoral impact. The presumption of technological neutrality is also unrealistic given that the development and adoption of new technologies, such as low-carbon goods and services, could mitigate the impact of climate change. Additionally, the model does not specifically include inputs such as human or natural capital which are usually linked to medium term growth. Finally, the underlying production function depends on various key parameters that are determined exogenously and whose values are difficult to estimate and will likely change over the medium term as climate change intensifies.

4 Investment in Line with NDCs Would Limit Economic Losses, but Would Cause Debt Dynamics to Deteriorate

Accomplishing the climate change mitigation and adaptation objectives included in the NDCs would entail significant investments (although not as much as what would be needed to fully compensate for climate change-related economic losses). Figures included in some NDCs suggest that annual adaptation and mitigation investment outlays in the period leading to 2030 could span a wide range from roughly 1 % of GDP to more than 20 % of GDP in some countries (Figure 2). Estimated annual investment needs for small island developing States (SIDs) in the Caribbean are especially large, reaching 21.8 % of GDP per year in the case of Dominica. Nevertheless, the lack of comprehensive investment requirements, both in magnitude and composition, is a major barrier to policy analysis and the formulation of climate financing mechanisms.

Figure 2:

Latin America and the Caribbean (selected countries): estimated annual financing requirements outlined in nationally determined contributions (NDCs) submissions (percentages of GDP). Source: Authors’ elaboration based on data from Climate Watch, [online] https://www.climatewatchdata.org/.

To examine the macroeconomic implications pursuing the actions outlined in the NDCs, the intensification of climate shocks scenario is modified to incorporate a climate change investment component. To make the models tractable despite the paucity of information on investment needs for the CAC6 countries, investment needs for all countries are set to the values presented by the Dominican Republic in the country’s first updated NDC submission.^[2] Additional annual investment in the NDC investment model is set to 1.8% of GDP, with 0.9% of GDP for mitigation and 0.9% of GDP for adaptation.

Investment requirements in the NDCs are not limited to public sector efforts, but also foresee the active participation of the private sector. In line with UNCTAD (2014), the model assumes that investment in adaptation is divided into 80 % for the public sector and 20 % for the private sector. In the case of mitigation investment, the public sector represents 40 % of the total while the private sector accounts for the remaining 60 %. The model therefore captures the impact of public and private NDC investment on GDP.

To analyze the impact of a front-loaded adaptation investment push, the model assumes that public adaptation outlays rise smoothly, doubling by the middle of the first decade of the projection period (2025–2034). Public adaptation investment subsequently declines, reaching a value that ensures that total public adaptation investment for the entire forecast period does not exceed the level that would have been observed if annual investment were held flat at the value, relative to GDP, obtained from the NDC of the Dominican Republic. In contrast, private sector adaptation investment is not front-loaded.

Under an NDC investment scenario, public investment would roughly double in most CAC6 countries during the first years of the front-loaded adaptation push but would remain at levels lower than those observed during the 2000s in most cases. Proactive front-loaded adaptation investment would result in a significant increase in public gross fixed capital formation (Table 3). However, public investment under an NDC investment scenario is not substantially higher than that seen in the early 2000s in Barbados, Dominican Republic, El Salvador, Guatemala, and Honduras. Public gross fixed capital formation after the initial front-loaded investment drive would remain above the levels that are projected to prevail over the projection period under the trend growth scenario. Investment levels in the counterfactual case should be considered a lower bound, although they are in line with recent trends.

An NDC investment push would attenuate the worst of the economic losses in the intensification of climate shocks scenario, but per capita GDP in CAC6 economies would still be between 5 % and 7 % smaller in 2050 than under the trend growth counterfactual (Table 4). A front-loaded adaptation investment push, and the accompanying increase in the capital stock, would accelerate growth in the short term and generate positive dynamic effects on economic activity in the medium term. Additionally, a growing climate adaptation capital stock would offset in part the impact of severe weather events on economic output (Annex 1). As a result, per capita GDP in the NDC investment scenario would situate itself roughly halfway between that of the trend growth counterfactual and the intensification of climate shocks scenario.

The impulse of NDC investment on growth may be understated in these results. Recent studies suggest that public investment fiscal multipliers could exceed unity in emerging markets and developing economies under certain conditions. Izquierdo et al. (2019) estimated a public investment multiplier above unity in Argentina, Paraguay and Peru, arguing that multipliers are higher in countries with a low capital stock, such as those in Latin America, than in those with a high capital stock. The same authors note that public investment is more likely to crowd-in private investment than primary expenditure, given the positive side effects that the former has on the marginal productivity of private capital. Additionally, Batini et al. (2021) find that the investment multiplier (public and private) for renewable energy and biodiversity conservation projects is in the range of 1.1–1.5, while that for fossil fuel energy projects and land use activities is considerably lower (0.5–0.6).

Losses in GDP per capita would be offset in part by NDC investment, declining instead between 5 % and 7 % compared to the trend growth counterfactual. The front-loaded climate adaptation investment push and capital outlays for climate mitigation could support economic activity, resulting in higher levels of GDP per capita than under the intensification of climate shocks scenario. Although GDP per capita could trend lower compared to the trend growth scenario, climate investments could generate significant positive secondary effects, supporting employment creation and the formalization of economic activity.

To assess the impact of an NDC investment push on public accounts, debt dynamics are modelled using the Debt Sustainability Analysis framework. Simplifying assumptions are employed to model debt dynamics for each scenario:

1. Total revenues – excluding carbon tax receipts – and current primary expenditure are assumed to grow such that their share relative to GDP remains constant over the projection period. Carbon tax revenues are included in the models based on the work of Titelman et al. (2022), although they are inconsequential for the models’ results.

2. Capital expenditure consists of three components: an inertial component, which assumes that capital expenditure grows such that its ratio with respect to GDP remains constant; a front-loaded climate adaptation investment component; and a climate mitigation investment component.

Movements in primary spending, and by extension the primary balance, are therefore entirely accounted for by changes in climate mitigation and adaptation investment. Debt dynamics are calculated using the modeled real GDP growth rate and primary balance, as well as the average effective interest rate on public debt (for the period 2018–2022) and inflation (GDP deflator from WEO), both of which are held constant over the forecast period.^[3]

Public debt levels are projected to remain elevated or experience accelerating growth in most CAC6 countries in the NDC investment scenario. As shown in Figure 3, debt levels grow rapidly in El Salvador, Guatemala, Honduras and Saint Lucia. Debt dynamics over the projection period in these countries are heavily influenced by the creation of large primary deficits due to greater public investment outlays. Lower growth, relative to the baseline case, also leads to a greater contribution of the interest rate-growth differential to the increase in debt. In El Salvador, debt levels accelerate rapidly under any scenario. In contrast, in Barbados and the Dominican Republic, the NDC investment big push would result in public debt levels that remain roughly at the levels estimated in 2024 before the forecast period. However, this would imply that public debt in Barbados would exceed 100 % of GDP.

Figure 3:

CAC6: central government gross public debt, by scenario, 2000–2050 (percentages of GDP). Source: Authors’ elaboration.

5 Lower Financing Costs of Climate Investment Could Have a Significant Impact on Debt Trajectories

High interest rates on public debt play a significant role in debt trajectories in the NDC investment scenario. The effective interest rate for public debt is elevated in most CAC6 countries. The average effective rate for the 2018–2022 period exceeded 5 % in the Dominican Republic (5.5 %) and El Salvador (5.5 %) and was 6.2 % in Guatemala and 7.0 % in Honduras. The effective interest rate for public debt was relatively lower in Saint Lucia (4.6 %) as well as Barbados (4.4 %), reflecting in large part the impact of the restructuring of public debt carried out in 2018 and 2019.

Effective interest rates may not adequately capture the market rates that countries would face if they were to finance NDC investment through debt offerings in international financial markets, where rates may be significantly higher. Cevik and Tovar Jalles (2020) find that climate vulnerable countries, especially developing countries, face significantly higher borrowing costs, even when controlling for factors that influence sovereign risk. Similarly, Beirne, Renzhi, and Volz (2020) argue that vulnerability to the direct effects of climate change is a significant driver of the cost of sovereign finance.

At the same time, Cevik and Tovar Jalles (2020) suggest that countries with higher climate resilience – the capacity to convert economic investments into adaptation actions – benefit from lower interest rates. Countries who cannot finance front-loaded climate adaptation and mitigation investments have potential to face a negative feedback loop.

Reducing the cost of climate finance could bend debt trajectories downwards and would allow countries to implement NDC investment while ramping up domestic resource mobilization. A major stumbling block to carrying out a front-loaded investment push is the lack of sufficient public revenues or low-cost debt finance. Proactive public climate investment efforts would become more viable if countries could access sufficient concessional finance.

To explore the extent to which concessional climate financing could impact debt dynamics, the NDC investment scenario was modified to use an interest rate that is one half of the prevailing effective interest rate for debt-financed public climate investment. Under this scenario, public debt largely stabilizes in the medium term in Saint Lucia (Figure 4). In Guatemala and Honduras, concessional financing softens the rise in public debt, which is projected in the NDC investment scenario without concessional finance but does not fully stabilize the medium-term debt curve. In the Dominican Republic and Barbados, concessional climate finance would lead to lower debt levels over the forecast period compared to the original NDC investment scenario. In contrast, debt dynamics remain unfavorable in El Salvador, even with concessional financing.

Figure 4:

CAC6: central government gross public debt, by scenario, 1990–2050 (percentages of GDP). Source: Authors’ elaboration.

6 Conclusions

Climate change is projected to have a strong negative impact on medium term economic growth and social welfare in Latin America and the Caribbean. CAC6 countries are particularly vulnerable to these shocks due to their geographical location, dependence on climate-sensitive economic sectors, and existing developmental challenges such as poverty and inequality. As presented in this article, the economic losses in CAC6 countries caused by changing hydrometeorological conditions and more intense severe weather events are estimated to be significant, with a sharp deceleration in per capita GDP growth. However, these results should be considered as a lower bound as the model used in this study does not fully account for the non-linear effects of climate risks on economic growth.

Offsetting the economic losses caused by climate change would require a sustained investment effort of unprecedented magnitude in these countries of between 5.3 % of GDP to 10.9 % of GDP per year on average. However, a front-loaded investment push of a smaller magnitude would improve medium term growth, although not completely compensate for the estimated losses from climate change. Such an effort, in line with countries’ Nationally Determined Contributions submissions, would roughly halve the estimated reduction in per capita GDP growth caused by climate change. However, pursuing a front-loaded investment push would negatively impact public debt dynamics, even when accounting for improved economic growth.

CAC6 countries already face significant debt-related development distress which limits fiscal space for active policymaking even though most of their current debt trajectories are sustainable. Borrowing costs, proxied by effective interest rates, are high in most CAC6 countries. These high interest rates make financing climate investments particularly difficult because they lead to higher interest payments, which in turn reduces the fiscal space needed to undertake proactive climate adaptation investments (ECLAC 2023b).

It is therefore essential to take steps to reduce the cost of financing to make climate and development investments fiscally viable over the medium term. We estimate that concessional climate finance, proxied by public debt issued with an interest rate of one half of the prevailing effective rate, could potentially make a front-loaded NDC investment push fiscally viable in most CAC6 countries. This result would be further improved by efforts to increase domestic resource mobilization, especially in countries like the Dominican Republic, Guatemala and Saint Lucia, where total tax revenues represented less than 20 % of GDP in 2022 (OECD et al. 2024).

Low-cost climate financing by international financial institutions is essential to meet investment needs. These entities can provide crucial financing to reduce the cost of capital and unlock investment. Between 2019 and 2020, multilateral institutions and national development banks provided an average of 11.5 billion US dollars (0.2 % of 2019 GDP) per year in climate finance in the region (CPI 2021). A significant portion was in the form of low-cost project debt or project-level market rate debt. However, this amount is currently insufficient to leverage the amount of private capital necessary to meet climate objectives. Multilateral institutions and national development banks should be further capitalized to increase their lending capacity.

It is also critical to build capacity to consider climate investment in policies. It is crucial to mainstream climate change policies in macro-fiscal planning, budgeting, public investment management, and public procurement. It is also necessary to encourage cooperation between countries and between development partners, such as international financial institutions and bilateral donors (The Coalition of Finance Ministers for Climate Action 2023). Technical assistance could play a catalytic role in helping governments adopt a strategic perspective and public policies that prioritize investments with high environmental, economic, and social returns. In this regard, it is important to consider projects with significant positive externalities even if they are not financially viable without assistance.

Furthermore, given that the impacts of climate change and the policies designed to combat them are not equitably distributed, it is essential to understand the distributive effects of policies that are going to be implemented and ensure that the vulnerabilities of low-income individuals and other populations are incorporated into policy analysis. Women, especially those living in poverty, are more vulnerable to the impacts of climate change and experience more significant risks and challenges. The inequalities they face are exacerbated because the majority of the world’s poor are women. Additionally, women’s unequal participation in decision-making processes and labor markets limits their ability to contribute to climate-related planning, policymaking, and implementation (UNFCCC 2022).