Disaster or Stress Test? IMF Study Shows Fragile Governments Pay More for Loans After Earthquakes
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Institutions: Ministry of Finance
A new IMF research paper “Earthquakes and Emerging Market Sovereign Bond Spreads” has found that when a major earthquake hits an emerging market (EM) country, the technical metric known as Sovereign Bond Spreads—which reflects the country’s borrowing cost—jumps up, but only if the government is seen as institutionally weak. The study, which looked at data from 96 countries, suggests that global investors don’t just see a natural disaster as an economic cleanup bill; they interpret the event as a “stress test” of the nation’s governance.
If a country has “low state capacity” (meaning its institutions, like its courts, bureaucracy, and financial management, are fragile), investors panic, causing the country’s interest rates to rise sharply and stay high for several months. This is essentially a market penalty for poor governance.
However, if a country has “high state capacity” (strong, reliable institutions), its borrowing costs remain stable or might even slightly fall, because investors trust that the government can manage the crisis and rebuild effectively. This shows that institutional quality, a non-economic factor, is the single most important factor determining a country’s financial stability when a disaster strikes.
The paper’s conclusion is clear: for countries at risk of natural disasters, the best way to lower borrowing costs and stabilize the economy is to invest in stronger institutions and better governance. Governments must integrate their plans for disaster financing with deep, long-term reforms to their debt and administrative structures, turning institutional weakness into resilience.
What are Sovereign Bond Spreads? → They refer to the difference in interest rates (yields) between a developing country’s government bond and a risk-free benchmark, typically a U.S. Treasury bond. They represent the risk premium demanded by investors for lending money to that government, reflecting the perceived probability of default and overall country risk.
Follow the full paper here: Earthquakes and Emerging Market Sovereign Bond Spreads, WP/25/218