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Sovereign Risk and Natural Disasters in

Emerging Markets
a
Jeroen Klomp
a
Development Economics Group, Wageningen University,
Wageningen, The Netherlands
Published online: 18 May 2015.

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 Emerging Markets Finance & Trade, 1–16, 2015
Copyright © Taylor & Francis Group, LLC
ISSN: 1540-496X print/1558-0938 online
DOI: 10.1080/1540496X.2015.1011530

Sovereign Risk and Natural Disasters in Emerging Markets

Jeroen Klomp
Development Economics Group, Wageningen University, Wageningen, The Netherlands

ABSTRACT: In this article, we explore the effect of large-scale natural disasters on sovereign default risk.
We use a heterogeneous dynamic panel model including a set of more than 380 large-scale natural
disasters for about forty emerging market countries in the period 1999–2010. After testing for the
sensitivity of the results, our main findings suggest that natural disasters significantly increase the
sovereign default premium paid by bond holders. That is, investors perceive natural disasters as an adverse
shock that makes the government debt less sustainable and eventually triggers a sovereign default. In
particular, it turns out that geophysical and meteorological disasters increase the credit default premium
in both the long run as well as in the short run, while hydrological disasters have only a temporary effect.
KEY WORDS: government default, natural disasters, pooled mean group
Emerging Markets Finance and Trade

It is widely documented that the increase in the frequency and severity of natural disasters since the
1970s have affected economic development in a number of significant ways, including staggering
economic growth (Loayza et al. 2012; Noy 2009; Raddatz 2009; Skidmore and Toya 2002;
Rasmussem 2004), reducing the accumulation of human capital (Cuaresma 2010) and worsening a
country’s balance of trade (Gassebner et al. 2010; Oh and Reuveny 2010).1 These negative economic
outcomes may aggravate the coming decades as the ongoing process of climate change is often linked
to natural disasters (IPCC 2001, 2007; Stern 2006). Currently, the estimated amount of physical
damage related to natural disasters is about $150 million annually and increases steadily by about 8
percent yearly (Guha-Sapir et al. 2012). A large share of these costs has to be paid by the government.
As a consequence, natural disasters may put considerable pressure on the public finances of a country
and subsequently affect the sustainability of the government debt.
According to the existing literature, there are three main channels through which natural disasters affect
the public finances. First, the government revenue base may weaken after a natural disaster since a
contraction in economic activity implies reduced tax revenues. Meanwhile, tax administration and collec-
tion may be hampered in the period following a catastrophe. Second, governments typically face increased
pressure on public spending due to unexpected expenses on short-term emergency relief operations. Third,
governments have to restore the public infrastructure such as roads and bridges, airports, harbors, and
public buildings that are damaged or destroyed after a natural disaster (Benson and Clay 2003; Borensztein
et al. 2009; Lis and Nickel 2009; Melecky and Raddatz 2015; Noy and Nualsri 2011).2
The unexpected increase in public spending together with a decrease in tax revenues makes the
government debt less sustainable and hence increases the likelihood of a sovereign default. For
instance, the hurricanes that struck Belize in 2000 caused an increase in the government expenditures
of about 5 percent of gross domestic product (GDP) the following three years. As a result, the fiscal
position worsened considerably and made the government debt increasingly unsustainable. Belize
eventually required a debt restructuring operation from the International Monetary Fund (IMF). More
recently, the 2013 annual economic outlook from Moody’s on the Caribbean reported that for many
countries in this region there is a high probability of relapse into default mainly due to the high
frequency of hurricanes and floods.

Address correspondence to Jeroen Klomp, Wageningen University, Development Economics Group, P.O. Box
8130, 6700 EW, Wageningen, The Netherlands. E-mail: jeroen.klomp@wur.nl
Color versions of one or more of the figures in the article can be found at http://www.tandfonline.com/mree.
 2 J. KLOMP

In the past decade, numerous studies have looked at this debate from an empirical perspective and
have explored how the economic consequences of natural disasters affect the fiscal position of the
government. Nevertheless, the general picture that is emerging in this literature remains unclear.
Several studies report a positive effect of disasters on the accumulation of government debt
(Freeman et al. 2003; Lis and Nickel 2009; Melecky and Raddatz 2015; Noy and Nualsri 2011).
For instance, according to Lis and Nickel (2009), the incidence of a single natural disaster increases
the long-run budget deficit between 0.2 and 1.1 percentage points of GDP. In contrast, many other
studies point out that most natural disasters have only a temporary effect on the fiscal deficit and the
sustainability of the government debt. In the aftermath of a disaster, spending jumps to alleviate
humanitarian emergencies and to begin reconstructing infrastructure. However, most natural disasters
do not affect the country’s ability or willingness to meet its external obligations on a permanent basis
(Benson and Clay 2003; Borensztein et al. 2009; Ouattara and Strobl 2013).
The existing evidence suffers from three important limitations. First, most studies try to explain the
effect of natural disasters on the annual change in the public finances using data on tax revenue,
government spending, deficit, or debt.3 However, natural disasters may also have important fiscal
consequences within the first weeks after the occurrence of the event, for example, by affecting the
ability of the government to raise capital on the government bond market to finance their short-term
obligations. It is a well-known fact that there is an outflow of foreign private capital shortly after a
disaster as the uncertainty of future repayment rises (Yang 2008). According to Benson and
Emerging Markets Finance and Trade

Clay (2003) and Borensztein and Smith (2009), the consequences of natural disasters on the debt
sustainability may differ between the long and short run. That is, in the short run, natural disasters
adversely affect the liquidity position of the government, while in the long run solvency may be
influenced. Second, in the short run, the reaction of investors may differ across countries in the
aftermath of a disaster. Under the efficient market hypothesis, security prices are assumed to reflect all
public information and to adjust swiftly to the arrival of new public information. Thus, when investors
already incorporate the fact that some countries are more frequently hit by a disaster than others, than
the effect should be smaller compared to an unexpected disaster. Finally, most studies examine the
linear effect of natural disasters on the accumulation of public debt. However, natural catastrophes may
also affect the sustainability of the public debt through a threshold effect. That is, when the widespread
economic consequences are large enough, it is possible that natural disasters generate a situation in
which the incumbent cabinet is unable to fulfill their debt repayment obligations and disasters trigger a
sovereign default.
Our study contributes to the empirical literature on sovereign risk by examine whether financial
markets are sensitive to changes in the sustainability of the government debt after the occurrence of
natural disasters in both the long and short run. We use a set of more than 380 large-scale natural
disasters for about forty emerging market countries in the period 1999–2010 reported by EM-DAT
(Guha-Sapir et al. 2012). As our proxy of debt sustainability, we use the monthly change in the
sovereign credit default premium. This premium measures the risk of a government default perceived
by investors. The use of the monthly credit default premium is more appropriate to examine the effect
of a natural disaster on debt sustainability than is the annual change in the government debt or deficit,
due to the short-run dynamics. We adopt a dynamic panel approach based on the pooled mean group
(PMG) technique first proposed by Pesaran et al. (1999). This estimator allows the short-run coeffi-
cients and error variances to differ freely across countries, but the long-run coefficients are constrained
to be the same.
After testing for the sensitivity of the results, our main finding suggests that large-scale natural
disasters increase the sovereign default premium paid by the bond holder. That is, natural catastrophes
reduce the sustainability of the government debt and, hence, increase the likelihood of a sovereign
default. In particular, it turns out that geophysical and meteorological disasters affect the credit default
premium in both the long run as well as in the short run, while hydrological disasters have only a
temporarily effect. This latter outcome can mainly be explained by the widespread physical damage
caused to the public infrastructure by meteorological and geophysical disasters.
 SOVEREIGN RISK AND NATURAL DISASTERS 3

Theoretical Foundation
A rise in the government debt due to a natural disaster increases the sovereign risk; that is, the risk that
a government defaults on or does not fully honor its bond contracts (Obstfeld and Rogoff 1996).4 The
sovereign risk of a nation depends on both the government’s ability and its willingness to repay its
debt commitments.5 Emergency assistance and reconstruction efforts call for higher government
expenditure, and, at the same time, tax revenue may shrink because of the decline in economic
activity. Consequently, the result is a deterioration of the fiscal balance. However, according to
Freeman et al. (2003), the fiscal consequences of natural disasters go beyond these direct costs
associated with physical damage. The indirect government costs are related first to a worsening of
the trade balance as the exporting capacity is hampered and imports for reconstruction surge
(Gassebner et al. 2010; Oh and Reuveny 2010). The external debt may eventually become unsustain-
able, and countries may require debt rescheduling. In addition, the effect on the revenue obtained from
trade policies is ambiguous. The revenues from import tariffs may increase in the aftermath of a
disaster, while the revenues from export taxes decrease. Second, the worsening of the trade balance
creates substantial downward pressure on the exchange rate, even more so since affected countries face
a liquidity constraint due to the outflow of foreign private capital shortly after a disaster as interna-
tional investors become more concerned about the repayment capacity of the government (Yang 2008).
As a result, the central bank has to run down their foreign exchange reserves, while the import costs
Emerging Markets Finance and Trade

and the real value of the foreign currency denominated debt of the government increases. According to
Panizza (2008), governments that switch from external to domestic debt could be trading a currency
mismatch for a maturity mismatch since few of them are able to issue long-term domestic debts at a
reasonable interest rate. Third, there can be inflationary pressures caused by production shortages and
higher import prices. In particular, the fiscal balance is reduced when taxes are collected before the
government spends, and therefore, the real value of tax revenues is eroded by inflation while the real
cost of spending is not, the so-called Olivera-Tanzi effect (Anušić and Švaljek 1996; Fischer and
Easterly 1990; Tanzi 1977, 1978).6 Therefore, combining all these indirect effects, the complete effect
on the government fiscal position may exceed the direct costs of relief and reconstruction from the
disasters.
As a preliminary test, we use an event window to explore how the public finances behave after the
occurrence of a large-scale natural disaster (Melecky and Raddatz 2015; Noy and Nualsri 2011;
Raddatz 2009). The results in Figure 1 indicate that in the first year after a disaster, the fiscal balance
decreases by about three percentage points (as a share of GDP), making the government debt less
sustainable. However, after two years, the fiscal situation of the government is starting to improve
again. These graphs clearly indicate that large-scale natural catastrophes deteriorate the public finances
and may adversely affect the sustainability of the public debt, at least in the short run.

Data and Methodology

Disaster and Debt Data
As our aim is to estimate the effect of natural disasters on debt sustainability, we have to quantify them
both. The data on natural disasters and their effects are documented in the EM-DAT “International
Disaster Database” (Guha-Sapir et al. 2012).7 The EM-DAT database has worldwide coverage and
contains records of more than 6,000 disasters between 1999 and 2010, our period of analysis. A
natural disaster is recognized when a natural situation or event overwhelms local capacity, necessitat-
ing a request for external assistance. For a disaster to be entered into the EM-DAT database, at least
one of the following criteria must be fulfilled: (1) ten or more people reported killed; (2) 100 people
reported affected; (3) declaration of a state of emergency; or (4) call for international assistance.
However, as pointed out by Gassebner et al. (2010), many of the disasters recorded in the EM-DAT
data set seem to have caused few casualties and little damage.8 Given this distribution of the disaster
 4 J. KLOMP
Emerging Markets Finance and Trade

Figure 1. Event analysis of natural disasters and fiscal policy.

 SOVEREIGN RISK AND NATURAL DISASTERS 5

data, it is conceivable that many of the disasters included in EM-DAT will not have had any effect on
government debt sustainability and hence on the perceived default risk by investors. For a disaster to
have an empirical effect on government debt sustainability, it should be of a magnitude that can
directly cause damage to the national production capacity and public infrastructure and affect a
substantial number of people.
For this reason, we adopt a decision rule, as suggested by Gassebner et al. (2010), which filters the
disasters included in EM-DAT. We decide to confine our empirical analysis to disasters that meet any
of the following criteria, which represent an adaptation of Munich Re’s natural catastrophe category:
(1) the number killed is not less than 1,000; (2) the number injured is not less than 1,000; (3) the
number affected is not less than 100,000; or (4) the amount of damages is not less than $1 billion. To
make estimates of damage comparable over time, we have converted dollar values into constant 2005
dollars using the U.S. GDP deflator. The adoption of this decision rule reduces the number of natural
disasters to about 600 globally between 1999 and 2010.
We distinguish between four groups of natural disasters: (1) hydrological disasters, including floods
and wet mass movements; (2) meteorological disasters, including storms; (3) geophysical disasters,
including earthquakes, tsunamis, and volcanic eruptions; and (4) climatic disasters, including extreme
temperatures, droughts, and wildfires. Figure 2 shows the number of disasters between 1999 and 2010.
The graph illustrates that hydrological disasters are the most common natural disaster (41 percent),
while less than 10 percent of the major natural disasters are categorized as a geophysical disaster. On
Emerging Markets Finance and Trade

average, there are about fifty-five major natural disasters annually. There is a statistically significant
increase in the number of natural disasters in the period 1999–2010 of about 2.5 percent annually.
To determine the effect of a natural disaster on debt sustainability, we construct for each country-
year the following disaster count variable that takes the timing of a disaster in the course of a month
into account (see also Noy 2009). This allows disasters occurring early in the month to have a different
contemporaneous effect than those that happen near the end of the month.

(P P
ðð31Dt Þ=31Þþ ðDt1 =31Þ
disasterit ¼ ρ ðpostÞdisaster month (1)
0 otherwise

Our disaster measure is calculated as the sum of (31—Dt)/31 in the disaster month and Dt-1/31 in the
postdisaster month, where D is the day of the disaster. In all other months, its value is set to zero.9 We
normalize the number of disaster events by the land area in 1,000 square kilometers, represented by ρ.

80
Number of large-scale natural disasters

70

60

50

40

30

20

10

0
1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010
Year

Geophysical Meteorological Hydrological Climatic

Figure 2. The number of natural disasters.

 6 J. KLOMP

Obviously, larger countries have a higher probability of experiencing a natural event (Gassebner
et al. 2010; Skidmore and Toya 2002).10
The motivation for using a count measure of disaster events is to reduce the potential endogeneity
of the disasters with respect to economic development. For instance, the number of people affected is
negatively related to the level of income, while the physical damage may have a positive relationship
with income. For this reason, it may be questionable to assume the exogeneity of disasters with respect
to economic development. The use of a count measure of disaster events reduces the potential
influence of endogeneity on our results.11
As our dependent variable, we use a sovereign risk measure based on the credit default premium
paid on a government bond.12 A sovereign credit default swap is an over-the-counter contract that
provides insurance against sovereign default. The protection buyer, the owner of a government bond,
makes periodic payments to the protection seller and in return receives a payoff if an underlying
government bond undergoes a credit event. The premium paid on the credit default swap depends on
the credit risk taken by the government. As such, the sovereign credit default spread directly reflects
the market’s assessment of the sovereign’s credit risk (Hull et al. 2004). An important advantage of
using sovereign credit default spread data is that it allows us to “factor out” the component of
sovereign bond returns due to changes in interest rates and focus instead on the returns due exclusively
to sovereign risk (Moser 2007). Furthermore, the sovereign credit default spread market may often be
more liquid than the corresponding sovereign bond market, resulting in more accurate estimates of
Emerging Markets Finance and Trade

credit spreads (Longstaff et al. 2007). The data on the credit default premium are primarily taken from
Thomson Datastream, supplemented with data from Bloomberg and J.P. Morgan. We include about
forty emerging market countries between January 1999 and December 2010.13
As a preliminary test for the exogeneity of the natural disasters in a country, we compare the credit
default premium before and after the occurrence of a natural event. The credit risk is more than 15
percent higher one month after the disaster and about 5 percent higher after one year. According to a
chi-squared test, both differences are significant at the 5 percent level. This nonparametric test
illustrates that after the occurrence of a natural disaster, the premium starts accelerating.
Nevertheless, within one year, a large part of the effect has disappeared.

Empirical Model
In this section we develop our empirical model used to examine the relationship between natural
disasters and sovereign risk. The relationship between debt sustainability and natural disasters can be
illustrated using a modified framework of the model proposed by Edwards (1984) and Favero and
Giavazzi (2007). Consider the situation in which a country either does or does not default at the end of
the period. When we assume that markets are competitive and lenders’ risk is neutral, the equilibrium
for an optimal portfolio allocation for a representative investor is given by

pðdt Þ  RRt þ ð1  pðdt ÞÞ  ð1 þ it þ st Þ ¼ 1 þ it : (2)

Using the logistic transformation of Equation (2), where p is the probability of default which depends
on the public debt-to-GDP ratio d at time t, RR the expected recovery rate, i the riskless rate of return,
and s the spread, we can represent this equation as follows

expðβk xkit Þ
p¼ ; (3)
1 þ expðβk xkit Þ

in which xkit denotes a k-vector of variables affecting sovereign default and β is the associated k-vector
of coefficients. Combining (2) and (3) and taking logarithms, we obtain the following equation
 SOVEREIGN RISK AND NATURAL DISASTERS 7

ln sit ¼ βk xkit þ lnð1 þ it  RRit Þ: (4)

For estimation purposes, it is often assumed that ln (1 + it – RRt) is equal to a country-specific

intercept αi and an error term εit. Plugging in these quantities, Equation (4) becomes

ln sit ¼ αi þ βk xkit þ εit : (5)

Most recent studies on explaining the sovereign spread are based on panel models in which it is
assumed that the data can be pooled. However, in view of the heterogeneity of the countries included
in those studies, this assumption may be questioned (Pesaran el al. 1996). Pesaran et al. (1999) argue,
for example, that the GMM estimation procedure for dynamic panel models can produce inconsistent
and misleading estimates if the sample is very heterogeneous. The econometric literature suggests two
approaches to consistently estimate parameters in dynamic panels with considerable heterogeneity.
First, under the so-called mean group (MG) estimator, an equation for each country is estimated, and
the distribution of the estimated coefficients across countries is examined. To be precise, this estima-
tion method produces consistent estimates of the average of the parameters in heterogeneous panels,
provided that country-specific parameters are independently distributed and the covariates are exo-
Emerging Markets Finance and Trade

genous. However, it has also been shown that MG estimates will be inefficient if parameters are the
same across countries; that is, if the long-run slope homogeneity restriction holds (Pesaran et al. 1999).
In this case, Pesaran et al. (1999) propose a maximum likelihood–based pooled mean group (PMG)
estimator that combines pooling and averaging of the individual regression coefficients. This estimator
allows the short-run coefficients and error variances to differ freely across countries, but the long-run
coefficients are constrained to be the same.14 Thus, not imposing equality of short-run slope coeffi-
cients allows the number of lags included to differ across countries.15 To anticipate the main results,
for our purposes, the pooled mean group estimator offers the best available compromise in the search
for consistency and efficiency.
Following Alexopoulou et al. (2010), Bellas et al. (2010), Catao and Terrones (2005), Ferrucci and
Penalver (2003), Hallerberg and Strauch (2002), and Rowland and Torres (2004), we estimate the
relation between the government default premium and natural disasters using an autoregressive
distributed lag ARDL(p, q1, . . . qn) specification based on a dynamic panel between January 1999
and December 2010. This technique allows separating the short-run and the long-run dynamics and
models the long-run convergence process under the form of unique coefficients for the variables in the
long run and heterogeneous ones in the short run.
The model to be tested can be written as follows

Δ ln spreadit ¼ ϕi ðln spreadit1  αi  βi xkitj  γi disasterit Þ  δi Δxkitj þ ηi Δdisasterit þ εit ; (6)

where spreadit is the five-year senior sovereign credit default premium (taken in logarithms) for
country i at time t; xkit-j is a vector containing the k control variables; disaster is our count measure
of natural disasters outlined above capturing the frequency. The number of time lags is represented by
j. We estimate the parameters γi and ηi by a difference-in-difference methodology, where countries
struck by a large-scale natural disaster in a particular year are the “treated,” and those that are not are
the “controls.” Under the efficient market hypothesis, security prices are assumed to reflect all public
information and to adjust swiftly to the arrival of new public information. Our hypothesis is that credit
default premium paid by bond holders is expected to increase (γi > 0; ηi > 0) in both the long and short
run in response to a natural disaster. The terms between brackets represent the long-run relationship,
with αi, the country-specific intercept and βi and γi the long-run coefficients on the explanatory
variables. These latter coefficients are restricted to be the same across countries to satisfy the slope
homogeneity condition in the long run. Moreover, for a long-run relationship to exist, the error
 8 J. KLOMP

correction coefficient ϕi , representing the speed of adjustment, has to be statistically significant

different from zero.
The vector of control variables xkit-j includes variables suggested by previous studies on explaining
differences in sovereign risk among countries (i.e., Baldacci et al. 2011; Bellas et al. 2010;
Ferrucci 2003; Moser 2007).16 These variables are required to capture the role of structural policies
and institutions and help to avoid an omitted variable bias. First, we include the ten-year U.S. Treasury
bond interest rates and three-month U.S. T-bill rate to control for the long- and short-term interest
rates. An increase in the interest rate will decrease the present value of the expected future cash flow.
Consequently, a rise in the interest rate increases the debt burden for emerging market countries
making the risk perception increase credit default premiums (Min et al. 2003). In addition, we add the
volatility index (VIX) of the Chicago Board Options Exchange as a proxy for financial market
uncertainty. The VIX measures the implied volatility from option contracts on the Standard and
Poor’s 100 index and can be interpreted as a forward-looking indicator on global risk aversion.
Furthermore, we include two variables that are related to the macroeconomic environment in a
particular country. First, we include the monthly change in the exchange rate. A less competitive
exchange rate affects the sovereign’s creditworthiness because it might lead to capital flight on the
expectations of future realignment (Sachs 1985). We also include the monthly returns of the stock
market taken from Thomson Datastream to control for the market return.17
In addition, we include the political risk measure of the Economic Intelligence Unit. The political
Emerging Markets Finance and Trade

risk determines the willingness to repay the government debt (Baldacci et al. 2011). The risk rating is
measured on a scale from 0 to 100 where 0 denotes the least or no risk and 100 the most risk possible.
Finally, we estimate all models throughout this study using year-quarter fixed effects.18

Empirical Results
This section presents the results on the relationship between natural disasters and the default risk faced
by the government. We determine the optimal number of lags for each variable using the Schwarz
Bayesian information criterion (SBC). All results are robust for alternative selection criteria, such as
Akaike information criterion (AIC) and the Hanna-Quinn information criteria (HQ). To obtain robust
standard errors, we use the bootstrap estimator with 1,000 replications of the Newton-Raphson
optimization algorithm to maximize the likelihood function.19
In column (1) of Table 1, we report our baseline estimation results. We test for long-run homo-
geneity using a Hausman test based on the null of equivalence between the PMG and MG estimations
(Pesaran et al. 1996). Not accepting the null implies rejecting homogeneity of the cross section’s long-
run coefficients.20 The joint Hausman test statistic fails to reject the long-run slope homogeneity
restriction at the 5 percent level. This implies that efficiency of the MG estimate is not warranted, and
so the PMG estimate should be preferred.21 The PMG results suggest that in the both the short and
long run there is a significant effect of the global factors that raise borrowing costs for emerging
market economies as suggested by the VIX index. That is, an increase in the degree of risk aversion of
investors tends to raise the credit default premium in both the long and short run (i.e., Arora and
Cerisola 2001; Dailami et al. 2005; Eichengreen and Mody 2000, 2004; Garcia-Herrero and
Ortiz 2006; Hilscher and Nosbusch 2010). In addition, an increase in the interest rates raises borrowing
costs and therefore also the likelihood of repayment problems of the government. To be more precise,
in the long run, the credit default premium is affected by the U.S. ten-year government bond yield,
while the three-month T-Bill rate affects the sovereign risk in the short run (cf. Bellas et al. 2010;
Ciarlone et al. 2009; Gonzalez-Rozada and Levy Yeyati 2008). Furthermore, an improvement in the
stock market returns is associated with a reduced credit default premium, which may reflect improved
economic perspectives (Baek et al. 2005). Finally, a positive change in the political risk is linked to a
higher sovereign default premium, potentially because it raises the uncertainty of repayment in both
the short and long run at a 5 percent confidence level (cf. Baldacci et al. 2011).
 SOVEREIGN RISK AND NATURAL DISASTERS 9

Table 1. Estimation results I: Baseline results

Dependent variable: Δ in spread

(1) (2) (3) (4) (5)

Long-run coefficients
VIX index 0.048** 0.049** 0.049** 0.047** 0.047**
(4.12) (4.22) (4.27) (4.12) (4.12)
U.S. T-bond ten-year 0.0381** 0.039** 0.037** 0.039** 0.037**
(3.98) (4.16) (3.92) (4.05) (3.94)
U.S. T-bill three-month 1.659 1.709 1.649 1.544 1.518
(1.44) (1.46) (1.49) (1.41) (1.48)
Change in the exchange rate 0.074 0.073 0.072 0.081 0.082
(1.21) (1.18) (1.18) (1.25) (1.25)
Market return −0.089 −0.093 −0.090 −0.080 −0.077
(−1.51) (−1.51) (−1.56) (−1.52) (−1.59)
Political risk 0.023* 0.023* 0.023* 0.023* 0.023*
(1.88) (1.79) (1.90) (1.80) (1.87)
Inflation 0.051 0.049
(1.64) (1.60)
Emerging Markets Finance and Trade

Volatility terms of trade 0.181 0.176

(1.44) (1.41)
External debt 0.175** 0.179**
(2.85) (2.95)
Government debt 0.912** 0.927**
(3.87) (3.95)
Fiscal balance −0.754** −0.748*
(−2.01) (−1.91)
Reserves to M2 −1.435 −1.374
(−1.44) (−1.37)
Current account −0.874 −0.846
(−1.52) (−1.46)

All large-scale natural disasters 59.154** 52.255**

(2.18) (2.14)

Geophysical disaster 77.055** 84.173**

(2.12) (2.33)
Hydrological disasters 43.681 50.079
(1.49) (1.57)
Meteorological disaster 58.157** 53.284*
(1.98) (1.85)
Climatic disasters 28.005 21.177
(1.54) (1.59)

Error correction coefficient 0.151** 0.153** 0.154** 0.401** 0.417**

(2.12) (2.09) (2.20) (2.12) (2.17)
Short-run coefficients
VIX index 0.122** 0.124** 0.127** 0.110** 0.116**
(7.01) (6.75) (6.95) (7.35) (7.15)
U.S. T-bond ten-year −0.035 −0.035 −0.036 −0.038 −0.038
(−1.41) (−1.37) (−1.42) (−1.43) (−1.41)
U.S. T-bill three-month 0.051** 0.051** 0.049** 0.046** 0.047**
(3.12) (3.05) (3.07) (3.17) (3.26)

(Continued )
 10 J. KLOMP

Table 1. (Continued)
Dependent variable: Δ in spread

(1) (2) (3) (4) (5)

Change in the exchange rate 0.041 0.039 0.040 0.039 0.039

(1.34) (1.29) (1.29) (1.25) (1.31)
Market return −0.127** −0.123 −0.128** −0.133** −0.129**
(−2.05) (−2.02) (−2.12) (−2.20) (−2.14)
Political risk 0.099** 0.097** 0.097** 0.098** 0.099**
(2.84) (2.90) (2.84) (2.96) (2.89)
Inflation 0.149 0.155
(0.30) (0.30)
Volatility terms of trade 0.089 0.093
(0.48) (0.46)
External debt 0.388 0.382
(0.67) (0.65)
Government debt 0.594 0.603
(1.27) (1.21)
Fiscal balance −0.488 −0.466
Emerging Markets Finance and Trade

(−0.71) (−0.71)
Reserves to M2 -0.16** -0.162**
(−3.39) (−3.27)
Current account −0.207** −0.216**
(−3.70) (−3.80)

All large-scale natural disasters 194.584** 132.916**

(3.05) (2.86)

Geophysical disaster 243.201** 206.013**

(4.79) (4.95)
Hydrological disasters 103.912** 113.741**
(2.08) (2.06)
Meteorological disaster 148.912** 104.534*
(1.98) (1.85)
Climatic disasters 42.912 27.080
(1.22) (1.21)

Observations 3,712 3,712 3,712 1,091 1,091

Implied R-squared 0.026 0.028 0.029 0.039 0.039
Hausmann test 0.383 0.376 0.394 0.784 0.684
Log likelihood p-value 0.000 0.000 0.000 0.000 0.000

Notes: The table shows short- and long-run results using the pooled mean group estimator. Bootstrapped t-values are
shown in parentheses. Values are estimated including time and country fixed effects. *Significance level of 10 percent;
**significance level of 5 percent.

In column (2) of Table 1, we include our broad count measure on large-scale natural disasters
incorporating the four types of catastrophes outlined above. In view of the unequal distribution of the
natural disasters across countries, we cluster the standard errors. For instance, about 50 percent of the
disasters occur in less than 10 percent of the countries. A one unit increase in our disaster count
measure increases the premium significantly in the short run by 194 percent and by 59 percent in the
long run. Our results provide some empirical support for the view of Panizza et al. (2009) that
 SOVEREIGN RISK AND NATURAL DISASTERS 11

countries are more likely to default in times of negative economic shocks. Using the average land area
size of the countries included (1.5 million square kilometers), after a country is being hit by an
additional natural disaster, the credit default premium increases immediately by about 13 percent in the
short run. In the long run, the credit default premium is raised by only 4 percent.22 These results
demonstrate that, although in the short run the credit default premium increases rapidly in response to
a natural disaster, in the long run there is little economic effect left on the risk of a sovereign default.
The significant error correction term ϕ indicates that approximately 15 percent of the adjustment to the
steady state takes place each month, or about 87 percent of the effect of a shock would disappear
within a year. Thus, the credit default premium adjusts fairly quickly to its equilibrium level, again
illustrating that natural disasters are particularly important in the short run as they seem not to have a
large permanent effect. Our empirical results so far give some empirical support for the hypotheses put
forward by Benson and Clay (2003) and Borensztein et al. (2009) that natural disasters may have
more important consequences for the sustainability of the public debt in the short run rather than in the
long run.
However, our large-scale disaster measure embeds different types of disasters, which can arguably
have different consequences. The various types of natural disasters included in our broad disaster
count measure differ in a number of respects. First, the numbers of natural events are not equally
distributed over the different types of disasters. For instance, there are twenty times more floods than
volcanic eruptions. Second, there is a large difference between the duration of a natural disaster. While
Emerging Markets Finance and Trade

an earthquake takes only a few minutes, the duration of a drought or flood can take up to three months.
Third, the types of disasters are not equally divided around the globe. For instance, Alexander (1993)
shows that most hurricanes occur within the tropics between latitudes 300 North and 300 South, but
not within +/-50 of the equator, where the atmospheric disturbances tend to be insufficient to cause
them. Finally, the disasters differ in the degree of predictability. Climatic and hydrological disasters
occur more frequently but can better be forecast than geophysical disasters as these disasters only
happen in certain parts of the year. Therefore, it is easier to take preparation measures by, for instance,
building dykes for floods, than taking physical precautionary measures for volcanic eruptions or
earthquakes.
Therefore, in column (3), we split our set of disasters into four groups: hydrological, meteorolo-
gical, geophysical, and climatic disasters. As some natural disasters such as storms and floods often
occur in tandem, simultaneous inclusion allows isolation of the effects of each disaster (Loayza
et al. 2012). The results indicate that geophysical and meteorological disasters have a significant
negative effect in both the long run and the short run, while hydrological disasters have only a
significant effect in the short run. One explanation for our results is that the physical damage caused by
geophysical and meteorological disasters is usually much larger than the damage caused by the other
kinds of disasters. To be more precise, based on the estimates of EM-DAT (Guha-Sapir et al. 2012),
the direct damage costs are about 2.5 times larger in the case of a geophysical disaster than for an
average climatic disaster. Our results point out that disasters affect the sustainability of the public debt
through the size effect rather than the frequency effect. This result contradicts the conclusions by
Melecky and Raddatz (2015), who argue that economic costs of a geological disaster are usually
passed through to the private sector. In addition, the insignificant effect of climatic disasters may be
caused by a sample selection bias as these disasters occur more frequently in African countries, which
are financially the least developed and hence have a less liquid default swap market, or such market
does not even exists at all.
In the estimated models so far, we only included control variables that are available on a monthly
basis. However, due to the limited number of available control variables, this may create a potential
omitted variable bias. To correct for this, we include some additional covariates and estimate the model
using quarterly data instead.23 First we include some additional variables related to economic stability.
Min (1998) argues that the sovereign risk depends on the macroeconomic and monetary policy
discipline. To control for this notion, we include the inflation rate. In addition, the volatility in
terms of trade may influence a country’s ability to pay. This is especially the case for emerging
 12 J. KLOMP

market economies where the economic performance depends on the primary commodity exports.
Furthermore, we include a set of variables that measure the solvency of a country. In general, solvency
variables measure the ability of the government to meet its long-term fixed expenses and the capacity
to absorb negative debt shocks (Min et al. 2003). To take the solvency position of a country into
account, we add external debt-to-GDP, government debt-to-GDP ratio, and the fiscal balance (lagged
one additional year to avoid simultaneity and endogeneity problems with the disaster measure). We
also include the total reserves-to-M2 and the current account-to-GDP as measures of liquidity
(Sachs 1981). Liquidity refers to the ability to fulfil the short-term obligations. In this specification
using quarterly data, the disaster variable is calculated as the sum of (91–Dt)/91 in the disaster quarter
and Dt-1/91 in the post-disaster quarter. In columns (4) and (5) of Table 1, we report the estimation
results including the additional covariates. The regression results point in the same direction as before.
Again we demonstrate that large-scale natural disasters raise the credit default premium. In more
detail, this latter result can be primarily attributed to the effect of meteorological and geological
disasters.

Conclusion
Emerging Markets Finance and Trade

In general there are three channels through which natural disasters affect the public finances. First,
governments typically face a weakened revenue base after a natural disaster since lower levels of
economic activity imply reduced tax revenues. Meanwhile, tax administration and collection may be
hampered in the period following a catastrophe. Second, the government is likely to face increased
pressures on spending due to additional resources allocated to short-term disaster relief operations and
to providing financial support to alleviate poverty. Third, governments have to restore the damaged
public infrastructure after a natural disaster.
The unexpected increase in public spending together with a decrease in tax revenues makes the
government debt less sustainable and may therefore reveal important signals for market participants
about the government’s default probability. This study contributes to the empirical literature on
sovereign risk by examining whether financial markets are sensitive to changes in the sustainability
of the government debt after the occurrence of large natural disasters in both the long and short run.
We use a set of more than 380 large-scale natural disasters for about forty emerging market countries
in the period 1999–2010, while the monthly change in the sovereign credit default premium is taken as
our proxy of debt sustainability. This premium measures the risk of a government default perceived by
investors. We adopt a dynamic panel approach based on the pooled mean group (PMG) technique.
This estimator allows the short-run coefficients and error variances to differ freely across countries, but
the long-run coefficients are constrained to be the same.
After testing for the sensitivity of the results, our main finding suggests that natural disasters
increase the sovereign default premium. That is, natural disasters decrease the sustainability of
the government debt and therefore increase the likelihood of a sovereignty default. In particular,
it turns out that geophysical and meteorological disasters affect the credit default premium in
both the long run and the short run, while hydrological disasters have only an effect on the
credit default premium in the short run. This latter outcome can mainly be explained by the
greater physical damage to the public infrastructure caused by meteorological and geophysical
disasters.
The results also demonstrate that, although in the short run the credit default premium increases
rapidly in response to a natural disaster, in the long run there is little economic effect on the risk of a
sovereign default. The credit default premium adjusts fairly quickly to its equilibrium level. Thus,
natural disasters may have more important consequences on the liquidity position of the government
rather than on the solvability.
 SOVEREIGN RISK AND NATURAL DISASTERS 13

Notes
1. An extensive working paper version of this article, including various empirical robustness tests of the
results, is available from the corresponding author upon request.
2. One exception is Fengler et al. (2008), who argue that the added reconstruction costs may be lower,
especially if much of the capital that was destroyed is no longer necessary. In such cases, the fiscal spending
burden can be smaller.
3. We define the effects of a disaster after one year as long run; the short-run effects are the fiscal consequences
within one year.
4. In the working paper version of this article, we present a formal theoretical model to explore the relationship
between sovereign risk and natural disasters.
5. As Reuss (1996) notes, willingness is a key factor that distinguishes sovereign loans from other types of
credit, as creditors have only limited legal redress when a sovereign government chooses not to repay its debt in
time even though it could do so. The main reason that countries repay is reputation. Countries repay to have the
opportunity to get access to funds of the financial markets in the future. The overview on the sovereign debt
literature by Panizza et al. (2009) concludes that a history of debt repayment problems has a strongly dampening
effect on the availability of new funds and a tightening of limits on arrears.
6. One can also argue that an increase in the price level has a positive effect on the debt sustainability due to
the inflation tax decreasing the government debt in real terms.
7. The database is compiled from various sources, including UN agencies, nongovernmental organizations,
insurance companies, research institutions, and press agencies. The EM-DAT data are publicly available on
CRED’s website at: www.cred.be. From the outset, it should be clear that doubts have been expressed about
Emerging Markets Finance and Trade

the accuracy of data on natural disasters, especially because often the major source of these data (national
governments) has an interest in inflating the measured effect. However, since biases should be random, using
data from one source should provide information about the relative magnitude of disasters and should thus be
appropriate for the hypotheses we examine here.
8. For example, only 10 percent of the disasters involve deaths of more than 100 people. A similarly small
proportion of disasters involves injuries to more than 100 people.
9. The count measure gives equal weight to the disaster events. This has the advantage of reducing the
potential influence of outlier events at the upper end of the disaster distribution. An alternative to the count
variable that we employ is to use a dummy variable that takes the value one if at least one disaster satisfying our
decision rule occurred during the calendar year. However, the advantage of a count variable is that it allows us to
obtain a more precise estimate of the effect of disasters on the likelihood of a debt crisis in a particular country-
year. In addition, the “frequency effect” captured by a count variable would be lost if one just uses a dummy
variable. In effect, the count variable allows us to retain more information about disasters than would the use of a
dummy variable. Nevertheless, as part of our robustness tests, we have also estimated the model using a dummy
variable to represent the occurrence of disasters satisfying our decision rule. The results remain in line with our
main findings throughout this article.
10. The number of natural disasters is correlated with the error term when we do not control for land size.
11. One can also argue that not only the consequences but also the occurrence of a natural disaster itself might
be endogenous. For instance, earlier literature on the causes and consequences of a natural disaster shows that
when the geographical location of a country is closer to the equator, there is a higher likelihood of a natural
disaster due to the climate. Likewise, earthquakes and volcanic eruptions occur along the fault lines between two
tectonic plates on land or the ocean floor (Kahn 2005; Lis and Nickel 2009; Pelling and Uitto 2001; Pelling
et al. 2002; Uitto 1998).
12. We use the change in the government credit default premium instead of the underlying government bond
because the first is more directly related to the concept of sovereign default risk.
13. In the appendix of the working paper, we summarize the countries included.
14. This estimator is particularly useful when the long run is given by conditions expected to be homo-
geneous across countries; the short-run adjustment depends on country characteristics. An important assumption
for the consistency of the PMG estimates is the independence of the regression residuals across countries. In
practice, nonzero error covariances usually arise from omitted common factors that influence the countries’
autoregressive distributed lag (ARDL) processes. We attempt to eliminate these common factors and, thus,
ensure the independence condition by allowing for time-specific effects in the estimated regression. For each
country, the order of the ARDL process must be augmented to ensure that the residual of the error-correction
model is exogenous and serially uncorrelated. At the same time, with a limited number of time series
observations, the ARDL order should not be overextended as this imposes excessive parameter requirements
on the data.
15. See Catao and Terrones (2005) and Hallerberg and Strauch (2002) for further discussions on using pooled
mean group regressions in fiscal policy models; Alexopoulou et al. (2010), Bellas et al. (2010), Ferrucci (2003),
and Rowland and Torres (2004) use this methodology explaining changes in the government bond spread.
 14 J. KLOMP

16. For an extensive survey on the determinants of emerging market sovereign default spread, see Rowland
and Torres (2004).
17. As an alternative, we use the growth of the industrial production and economic growth; the results remain
in line.
18. In the appendix of the working paper, we provide an overview of all variables, their definition as well as
their source. We also provide in this appendix the statistics related to the cointegration tests.
19. By weighting the observations, we make the data more representative of the population to account for
missing data.
20. An alternative to the Hausman test is the likelihood ratio test for short-run or long-run parameter
heterogeneity that has homogeneity as the null (Hsiao et al. 1999). The results of the likelihood test throughout
this article do not differ from the Hausman test and are available upon request. As outlined in the previous section,
the consistency and efficiency of the PMG estimates rely on several specification conditions. The first is that the
regression residuals are serially uncorrelated and that the explanatory variables can be treated as exogenous. The
second condition is that both country-specific effects and cross-national common factors are accounted for. We
control for country-specific effects by allowing for an intercept for each country, and we attempt to eliminate
cross-national common factors by demeaning the data using the corresponding cross-sectional means for every
period.
21. The individual MG estimation results are available upon request.
22. Computed in the following way, in the long run the effect is (59/1500) × 100 ≈ 4 percent, while in the short
run the effect is (194/1500) × 100 ≈ 13 percent.
23. For some of the data, we have interpolated annual data to obtain quarterly observations.
Emerging Markets Finance and Trade

Acknowledgements
We like to thank two anonymous referees and the editor for their very helpful comments on a previous
version of the article.

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