Compounding COVID-19 and climate risks: The interplay of banks’ lending and government’s policy in the shock recovery

Abstract

We assess the individual and compounding impacts of COVID-19 and climate physical risks in the economy and finance, using the EIRIN Stock-Flow Consistent model. We study the interplay between banks’ lending decisions and government’s policy effectiveness in the economic recovery process. We calibrate EIRIN on Mexico, being a country highly exposed to COVID-19 and hurricanes risks. By embedding financial actors and the credit market, and by endogenising investors’ expectations, EIRIN analyses the finance-economy feedbacks, providing an accurate assessment of risks and policy co-benefits. We quantify the impacts of compounding COVID-19 and hurricanes on GDP through time using a compound risk indicator. We find that procyclical lending and credit market constraints amplify the initial shocks by limiting firms’ recovery investments, thus mining the effectiveness of higher government spending. When COVID-19 and hurricanes compound, non-linear dynamics that amplify losses emerge, negatively affecting the economic recovery, banks’ financial stability and public debt sustainability.