By Susan Burns, Founder, Global Footprint Network | 26 November 2013
In the past two years, the sovereign debt of the USA, as well as Spain, Greece, Portugal and other nations primarily in the Eurozone, were downgraded. Sovereign bonds, especially of OECD countries, have generally been considered safe securities, but that picture is now quickly changing.
One of the hidden drivers behind the financial turmoil is the dramatic increase in resource prices over the last 10 years. Historically, cheap resources have helped fuel economic growth, but rising costs of key commodities have reversed more than two decades of stable or falling prices. Countries are seeing their import bills for both biological resources (fish, timber, wheat and other soft commodities) and fossil fuels rise. Increasing costs impose a burden on economic performance that, in some cases, is reflected in rising debt levels. At the same time, the ability of many countries to service this debt is being called into question.
With more than $40 trillion of sovereign debt in global markets at any given time, it is vitally important to understand how resource trends can affect national economic performance in the 21st century. Do capital markets sufficiently account for ecological risks? Are such factors reflected in the assessment of fixed income securities? These and other questions prompted Global Footprint Network and its partners to look more deeply at the link between resource constraints, economic performance and sovereign debt ratings.
Uncovering Ecological Risk
Our research reveals that indeed, ecological risks are material and that many nations are exposed to resource risks to a significant degree. Second, rather than evenly impacting nations, ecological risks have a very uneven impact on countries’ economic performance depending on their resource profile, their trade profile, the structure of their economy, and their financial resilience to risk. Third, these impacts are poorly reflected in current risk models. Further, contrary to popular thinking, environmental risks are not only a long-term concern, but their consequences can also be significant in the short term. In particular, a nation’s exposure to trade-related risks can have immediate impact in a time of commodity price volatility.
The Resource Link
Today, 80% of the world’s population lives in countries that are running “biocapacity deficits,” meaning that they use, in net terms, more resources and ecological services than their own ecosystems can renew. At no other time in history has human demand on resources been greater, with the rate of consumption exceeding the Earth’s capacity to regenerate raw materials for food, shelter and clothing, and to absorb the carbon dioxide we emit. Resources—from their scarcity, to their rising costs, to countries’ abilities to secure them— are increasingly becoming economic factors.
The New Normal
The increase in resource prices in the past decade has been the most sustained and broadest ever recorded, affecting nearly all commodities across agricultural products, minerals, and fuels. Between 2001 and 2011, the price of commodities increased by nearly three times in nominal U.S. dollar terms, reversing more than two decades of stable or falling prices.
Figure 1: Average commodity prices for energy, food, raw materials, and metals and minerals, as indexed by the World Bank (relative movements in constant U.S. dollars; 100 = year 2000).
While the drivers of these price increases are complex, one driver is a global supply crunch. The supply of some ecosystem products (such as food and fibre) no longer matches the growing demand, nor can the more easily exploitable fossil fuel and hydro energy sources meet current needs. Some analysts believe this isn’t a temporary trend, rather, that volatile and increasing commodity prices represents the “new normal.”
Trade can be key to a country’s ability to cover its resource deficit. However, not all countries can become net importers of ecological services and resources. Instead, the growing global competition for limited resources, coupled with rising global demand, will likely tighten the market for both biological and fossil resources even further. Increasing demand can also lead to overuse of a nation’s forests, fisheries, cropland and grazing land, leading to degradation and a reduction in their productivity, which also has economic consequences.
Uncovering Resource Risk
Last year in partnership with UNEP FI and 15 leading financial institutions we examined the resource trends and their economic implications for five diverse countries: Brazil, France, India, Turkey, and Japan. The methodology, called E-RISC (Environmental Risk in Sovereign Credit) has now been applied to over 100 nations.
The E-RISC methodology relies on Global Footprint Network’s Ecological Footprint and biocapacity accounts, a set of resource accounts for over 260 countries with time trends dating back to 1961. The Footprint’s focus on renewable biological resources (such as fisheries, forests, cropland and grazing land) is supplemented with data on non-renewable natural resources including fossil fuels, metals and minerals to provide a more comprehensive definition of natural resources.
Figure 2: The Ecological Footprint methodology measures the supply and demand of biocapacity in six land-type categories: urban land, fishing grounds, crop land, grazing land, carbon land for CO2 sequestration, and forest land for fiber.
E-RISC demonstrated how importers and exporters of natural resources such as fossil fuel, timber, fish, and crops are being exposed to the increasing volatility that accompanies rising global resource scarcity. Indeed, we estimated that a 10% variation in commodity prices could lead to changes in a country’s trade balance amounting to more than 0.5% of GDP.
Meanwhile, the economic consequences of environmental degradation can be severe. The report estimates that a 10% reduction in the productive capacity of soils and freshwater areas alone could lead to a reduction in the trade balance equivalent to more than 4% of GDP.
Of the five countries featured, Brazil has the most biocapacity of any country and scores in the top quartile of nations in the E-RISC score (with lower numbers representing less risk). Even so, as natural resources constitute key export products for Brazil, the economy is fairly vulnerable to changes in commodity prices: a 10 per cent price change could lead to a change in the country’s trade balance equivalent to 0.38 per cent of GDP.
This effect is less for countries like France whose relatively balanced trade reduces vulnerability to price volatility, although fuel prices do present risks. France also ranks in the top quartile in its E-RISC score. The small contribution of agriculture and agricultural employment to GDP reduces the impact that environmental degradation may have. Additionally, there is little evidence of degradation linked with overuse in France.
Turkey’s increasing dependence on imported resources has increased its vulnerability to trade-related risks, contributing to a higher risk score and its placement in the second quartile. Agriculture remains economically important in terms of output, exports and employment. As a result, Turkey is highly exposed to risks linked to the environmental degradation that is worsening in the country.
Japan’s very high rate of dependence on foreign natural resources, including fossil fuels, make its trade balance highly vulnerable to commodity price volatility. It also placed in the second quartile in terms of ecological risk. Over the past decades, an increasing share of this biocapacity deficit has come to be met by imports. Indeed, in biocapacity
terms, Japan has gone from meeting 73 per cent of its renewable natural resource needs from domestic sources in 1961 to only 35 per cent in 2008.
India had the highest risk score of the five case study countries and placed in the bottom quartile. In spite of its high self-reliance in agricultural commodities, India’s dependence on imported fossil fuels makes it highly vulnerable to commodity price volatility. Also, agriculture accounts for over half of all employment in the country. Loss of productive capacity due to overharvesting of resources may therefore have important adverse socio-economic effects.
Environmental risks are potentially large enough to affect countries’ economies in ways that could influence their willingness or ability to repay sovereign debt. In addition, these risks vary widely across countries, including countries whose similar current credit ratings mask this variability in a material contributor to sovereign risk.
The Way Forward
Incorporating these new risks into investment decisions will not only safeguard investments but also, because of the importance of credit markets to national governments, incentivize countries to protect their natural wealth. As financial markets incorporate these risks, a systemic shift in the way governments set policies and make investments could occur. Governments which take early action to address their environmental risks will be best placed to benefit from the changes in investment patterns that will occur when these risks are better quantified and integrated.
The time has come for a better understanding of the connection between environmental and natural resource risk and sovereign credit risk. Only then will investors, rating agencies, and governments be able to plan over the medium to long-term with the knowledge needed to ensure lasting prosperity and stability.