Do climate risks influence foreign direct investment inflows to emerging and developing economies?

Abstract

ABSTRACT Foreign direct investment (FDI) inflows are considered to be an important source of private financing for several emerging markets and developing economies (EMDEs). However, the high susceptibility of these countries to climate change impacts vis-à-vis their developed counterparts may reduce their attractiveness as a favourable destination for FDI inflows. EMDEs with significant exposure to physical climate risks present a higher incidence of financial risks for foreign investors, which may in turn discourage them from locating themselves in such jurisdictions where their profitability and operations could be jeopardized by climate disasters. Given this context, we empirically investigate how physical climate risks influence FDI inflows to 68 EMDEs using data from over two decades, from 1995 to 2017. We contribute to an emerging body of literature that assesses the impact of climate risks on macro-financial variables by focusing specifically on FDI inflows. Although we abstain from making strong causal claims in our paper, we account for endogeneity concerns extensively and our empirical results show that higher climate risks adversely impact FDI inflows to EMDEs. However, we find these negative effects can be mitigated to a significant degree by strengthening financial sector development in the host country, as it increases their capacity to absorb some of these climate risks more effectively. Key policy insights Emerging markets and developing economies (EMDEs) that are more vulnerable and exposed to physical climate risks tend to be less attractive destinations for FDI inflows. Negative effects of physical climate risks on FDI inflows tend to be mitigated in EMDEs with a high degree of financial development. Well-developed, deep, and inclusive financial markets give EMDEs the capacity to absorb and manage various financial risks including those arising from climate change impacts.