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Sovereign Default Risk and Climate Change: Is it Hot Enough?

We estimate the effects of temperature anomalies – temperature’s deviation from its long-run mean – on sovereign default risk and explore the transmission channels. We use cross-country panel data covering 76 countries over the period 1999-2017. Our results suggest that an increase of temperature leads to an increase of the sovereign credit default swap (CDS) premium. Building on an equilibrium bond pricing equation, we document the existence of a “debt limit channel” of temperature: higher temperature, relatively to the long-run mean, has a negative impact on future growth rate, which lowers the country’s debt limit – the maximum debt-to-GDP ratio it can sustain without defaulting. As a result, the probability of default increases, leading to a higher CDS spread.