Effects of Climate Risks on Financial Stress: Evidence From Asia-Pacific Countries

ABSTRACT: Measurement of climate shocks on financial stress is essential as climate change poses significant risks to financial stability. Providing evidence on the delay, the depth, and the persistence of the shock on financial stress could help us to better understand how the market reacts to uncertainty related to climate risk. To estimate this, the local projection methodology by Jordà (2005) is used, to assess the effect of climate shocks on financial stress indices over various time horizons. This approach allows for the estimation of impulse response functions, providing a clear graphical representation and an adaptable depiction of the dynamic impact of climate shocks over time. Relying on data from 1995 to 2023 at a monthly frequency for Asia-Pacific countries, we analyze the financial market's reaction to a shock in first and second moment of changes in climate risk. The latter is measured trough changes and volatility in temperature anomalies. Results show that heightened climate volatility, particularly through temperature anomalies, significantly impacts various financial indicators within Asia-Pacific markets. The Financial Stress Index experiences an initial spike in response to temperature anomaly shocks, which diminishes over time, indicating that the market eventually absorbs such shocks. The persistent effect observed in the first differences of the FSI suggests ongoing fluctuations in financial stress due to climate risk. Different financial components react distinctively: debt spreads indicate increased systemic risk; the Exchange Market Pressure Index shows heightened pressure and equity markets reflect delayed but significant volatility responses. Financial stress Index experiences a delayed positive response, primarily originating from the volatility of the changes in temperature anomalies. These findings highlight the multifaceted and temporal nature of climate risk impacts on financial markets. Policymakers should incorporate climate risk assessments into financial stability monitoring frameworks, emphasizing the development of robust climate stress testing methodologies. It is equally important to stress the role of transparency and enhancing climate risk disclosure requirements for financial institutions. These measures are crucial for managing investor expectations and reducing market uncertainties. Encouraging collaboration among regulators, financial institutions, and investors is vital for achieving a sustainable, climate-conscious financial landscape.