Climate change is expected to increase drought conditions in many developing countries, leading to large agricultural productivity losses. Standard trade and geography models predict that the optimal adaptation response is a reallocation of economic activity away from affected regions towards other areas with higher returns. We study the effects of recent changes in climate in Brazil to understand to what extent labor and credit market frictions shape this reallocation process. We develop a spatial equilibrium model where banks reallocate credit across regions through their branch networks and workers can migrate. While persistent increases in dryness generate migration outflows from affected areas towards other regions, credit reallocation follows a different pattern. In the short run, banks provide insurance to drought-affected regions by channeling capital inflows from connected areas. When increases in dryness become persistent, loan defaults reduce bank liquidity and generate credit contractions throughout branch networks. This credit disruption channel propagates agricultural shocks to regions not directly affected by climate change.
Co-authors: Paula Bustos, Jacopo Ponticelli and Martí Mestieri
