In our fast-paced, ever-changing global economy, a country’s sustainability is critical when shaping its future. The interplay of climate change, shifting demographics, political polarisation, and geopolitical instability can profoundly affect a nation's competitiveness, growth, and inflation.

This makes the integration of sustainability analysis into sovereign investing an essential consideration. At Schroders, we've delved into this complex topic, focusing on three key themes - climate risk, education, and socio-political stability - and their impact on a country's sovereign credit outlook.

1.Climate risk: vulnerability, readiness, and emissions

The physical risks associated with climate change have a direct impact on agricultural activities, food availability, and pricing, which could potentially escalate inflation risks and adversely affect countries reliant on imports. Similarly, countries exposed to extreme heat and flooding can suffer significant economic damage. This is not a new or novel consideration for investors, but one that requires detailed attention as countries evolve climate agendas and implement policies to enable solutions.

Since the 1970s, there have been US$4.3 trillion in economic losses from climate change, US$1.7 trillion of which occurred in the US. However, when considering economy size, the effects are disproportionate. Developed countries experienced economic losses equivalent to less than 0.1% of GDP in more than 80% of disasters, with no losses greater than 3.5% of GDP. In contrast, in the least developed countries, losses equated to more than 5% of GDP, including disasters causing losses up to nearly 30% (Source: World Meteorological Organization, 2023).

Physical risks have direct economic impacts, including property damage, and indirect impacts in the form of resource scarcity and supply chain disruption. Climate adaptation, through proactive infrastructure rehabilitation or improving ecological networks, can mitigate the economic damage related to these physical risks.

Our research with Cornell University projected that four countries with high exposure to heat stress would have a combined export earnings opportunity cost of US$65 billion and nearly one million jobs not created versus a climate-adaptive scenario.

Transition risks and opportunities manifest through a country’s climate policy agenda and can include scaling up or rolling back climate efforts. Technological advancements, the availability of natural resources, or the development of transition-focused services provide the rationale for capital deployment in this area. Through strategic policymaking, governments can stimulate economic growth while counteracting the potential GDP losses that could result from inaction.

Sustainable sovereign investors must pay attention to how these issues affect borrowing costs, whether through lower GDP, changes in fiscal or monetary policy, or structurally altered inflation expectations. Policy changes such as the Inflation Reduction Act (IRA), the EU’s Critical Raw Minerals act, or China’s decarbonisation plan are increasing in scale and potency, with potentially profound economic consequences.

As it relates to carbon emissions, governments may consider policy which implements pricing mechanisms to reflect a country’s performance. High-emitting economic activity faces penalisation, which will affect sovereign debt valuations. However, given the lack of global carbon policies, considerations such as a country’s share of global emissions are less material in sovereign debt valuation versus its approach to transitioning and demonstrating ‘climate readiness’.

Climate readiness, as measured by the ND-GAIN index, captures the ability of a country’s business environment to accept investment to reduce its vulnerability. It also considers institutional factors, as well as the education and innovation that enhance the mobility of said investment.

CHART 1: Climate Readiness and 10-year Bond Yields (five-year average.)

Investors who proactively assess and understand the value of a country's specific initiatives to facilitate a transition or adapt to physical risks stand to gain insights into possible shifts in yields and the liquidity profile of countries making genuine progress. Countries that are making significant progress in their transition or adaptation efforts should contribute to the reduction of any risks associated with their yield rates.

2. Demographics: education, innovation and “brain drain”

Demographics also play a role, with pressures on long-term debt trajectories stemming from rising age dependency ratios and persistent income inequalities. Education, a value-creating investment in human capital, can offset such inequalities and strengthen fiscal sustainability, as long as the impact of brain drain (emigration of higher educated individuals) is kept to a minimum.

Education can positively impact economic growth and productivity. For every US$1 spent on education, up to US$15 in economic growth can be generated. However, the impact varies depending on the nature of labour skills required in the economy.

In a knowledge-based economy, original ideas and methods pursued by individuals can be utilised by others, fostering social value creation and potential economic growth, such as innovation across industries.

The Global Innovation Index (GII) provides insights into a country's innovation performance and potential growth driven by the knowledge economy. This provides a comprehensive view of a country's innovation capabilities and efficiency.

The chart below highlights that countries such as Switzerland, Sweden, the UK, and South Korea excel in converting innovation inputs into tangible economic outputs. For example, Sweden ranks 4th in input and 2nd in output; South Korea ranks 16th in input and 4th in output. The US on the other hand ranks 2nd in input, but only 5th in output, highlighting that there are inefficiencies in the diffusion and/or adoption of domestic innovation.

CHART 2: Innovation input to output performance, 2022

However, talent mobility and migration, or "brain drain," can have significant impacts on a country's domestic capabilities and future growth.

Countries such as Sweden, Denmark, Australia, and Canada have historically kept talent at home and continue to do so. Net exporters of talent over 10 years include the US and Japan. Our research suggests that the countries that have experienced lower displacements (or brain drain) over the past 10 years saw an average economic growth of 2.4% versus 1.4% for the countries that were net exporters (US, Japan, Portugal, UK, South Africa, France, and Austria).

It is also worth highlighting that the set of countries with historically lower displacements (i.e., Denmark, Canada, Australia, Germany) are not only experiencing more growth on average, but are also seeing that mirrored with lower funding costs.

3. Socio-political stability

Lastly, socio-political stability can affect political risk premia by reinforcing or undermining institutional strength. Polarisation at political levels can reduce government effectiveness, negatively impacting a country’s ability to act on relevant policy with economic necessities and benefits in mind.

Socio-political instability can lead to significant economic costs, including industry and supply chain disruptions, reduced productivity, devaluation of investment opportunities, and diminished economic growth prospects. In contrast, politically and socially stable countries foster business-friendly environments, encouraging sustained economic growth.

CHART 3: Political & Business Stability compared with 10-year Bond Yields (five-year average) and % change in CPI (five-year average)

Conflicts or wars can put a significant financial burden on a country, mainly due to escalated military spending, which might lead to increased borrowing and higher bond yields. Conversely, politically stable nations often enjoy lower bond yields and reduced inflation volatility. Of particular relevance to emerging markets is that they are more likely to attract foreign direct investment if they are politically stable.

Polarisation can result in policy gridlock, volatility, or uncertainty, leading to negative economic consequences. For instance, disagreement on clean energy transition policies can result in missed economic opportunities and hinder job growth. The IMF found that political instability significantly reduces economic growth and discourages physical and human capital accumulation.

Overall, the negative effects of political instability on sovereign credit are significant. Conflicts and geopolitical divides can disrupt economic activity, discourage investments, and impact growth. For investors, it's crucial to consider a country's resilience, adaptability, and ability to navigate geopolitical challenges while remaining competitive. This includes trade, access to financial markets, and consensus-building on domestic policy agendas.