A looming credit crisis can befall the world’s most vulnerable populations, according to a report by the Climate and Sustainability Initiative (CSI). Its reasoning is that the rising frequency of climate-driven disasters is fundamentally undermining the global micro-finance model, threatening to reverse decades of progress in poverty alleviation.

Titled ‘Micro-Loans, Macro-Shocks’, the report found a dangerous feedback loop where climate shocks, such as floods, droughts, erratic monsoons, and extreme heat, are not only destroying the livelihoods of low-income borrowers but are also driving up the cost of capital for the institutions that serve them.

According to the report, climate change poses an active, structural risk to a sector that serves over 70 million low-income households and holds an outstanding portfolio of ₹3.81 lakh crore. 

It found that the sector’s portfolio at risk more than tripled in FY24–25, from 2.1% to 6.2%. The outstanding loan portfolio also shrank 14%. 

In simpler terms, climate shocks are reducing borrower incomes and weakening repayment capacity in ways that credit discipline norms alone cannot address.

Increasing poverty

The report found that there is a climate premium in the lending market. As international credit rating agencies increasingly incorporate climate risk into their assessments, the sovereign borrowing costs for developing nations are spiking. The report notes that countries most exposed to climate hazards now pay interest rates up to 1.5% higher than their less-exposed peers.

This macro-level financial pressure trickles down to micro-finance institutions (MFIs). 

Majority of borrowers from MFIs are engaged in agriculture or allied activities, and are naturally vulnerable to climate change. “They are more likely to not repay their loans due to these problems. Once they default, they will be cut off from getting future loans,” said Labanya Prakash Jena, Director, CSI. 

“As a result, micro finance institutions will be much more vulnerable, as the non-performing assets (NPAs) of their loan books will increase.”

The report found that when a nation’s credit rating is downgraded due to climate vulnerability, the local micro-lender faces higher funding costs. These costs are inevitably passed down to the smallest borrowers — farmers, market traders, and rural entrepreneurs — who are already struggling to recover from the physical impacts of climate change.

Possible reforms

The report calls for an immediate overhaul of how global finance handles climate risk in the Global South. Key recommendations include:

• Climate-Adjusted Credit Frameworks: Urging rating agencies to credit countries for resilience gains, such as building sea walls or diversifying energy grids, rather than focusing solely on downside risks.

• Expansion of the IMF’s Resilience and Sustainability Trust: Scaling up specialized capital instruments to provide low-cost, long-term financing to MFIs.

• Parametric Insurance Integration: Automatically triggering payment holidays or debt relief for micro-borrowers the moment a pre-defined climate threshold (like wind speed or rainfall) is breached.

For borrowers, providing direct benefit transfer schemes can help, said Jena. “When the central government gives money directly to the people, they will have financial support, and they will also not default on their loans.”

“If governments can create a fund dedicated to serving MFIs, then that will help during times of crisis. If MFI is facing risk, then this fund can help the MFI with letters of credit. During extremes, this fund will help MFI with liquidity problems,” said Jena.

Without systemic financial reform, the macro-shocks of the climate crisis will continue to break the micro-loans that support the world’s poor.

“Climate risk is not waiting for the sector to catch up. Borrowers in flood-hit Bihar, drought-prone Odisha, and heat-stressed agricultural belts are already missing repayments, not because they are poor credit risks, but because their harvests have failed or their livestock have died. The microfinance sector needs to stop treating these as one-off events and start designing for the world that already exists.” said Dr. Insha Ahad Wani, Consultant, CSI.

Originally published in Carbon Copy.