POWER PLAYS AND CONSEQUENCES

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A description of how financial fragmentation caused by geopolitical crises affects the global economy.


 

Concerns about global economic and financial fragmentation have grown in recent years as a result of escalating geopolitical tensions, strained US-China relations, Russia’s invasion of Ukraine, and most recently, the Israel-Palestine conflict. Fragmentation of the financial system refers to a lack of full traceability of central bank reserves across borders which cannot be explained by technical or fundamental factors. Financial fragmentation has serious consequences for global financial stability since it affects cross-border investment, international payment networks, and asset markets. This, in turn, fuels instability by increasing bank funding costs, decreasing profitability, and restricting lending to the private sector.

An increase in tensions between an investing and a receiving country, such as the US and China, can affect overall bilateral cross-border allocation of portfolio investment and bank claims. China-US relations after 2016 had affected investments and claims by roughly 15%. Investment funds are especially sensitive to geopolitical tensions and tend to restrict cross-border allocations to nations with different foreign policy perspectives.


DURING GEOPOLITICAL CRISES, THERE IS AN INCREASED NEED FOR MUTUAL ASSISTANCE AGREEMENTS BETWEEN COUNTRIES TO ESTABLISH A GLOBAL FINANCIAL SAFETY NET – A SYSTEM OF ORGANISATIONS AND PROCESSES THAT GUARANTEE AGAINST CRISES AND FINANCE TO MINIMISE THEIR DAMAGE.


Geopolitical tensions undermine financial stability. Financial restrictions, greater uncertainty, and cross-border credit and investment outflows caused by an increase in tensions may increase banks’ debt rollover risks and funding costs. It may also raise interest rates on government bonds, lowering the value of banks’ holdings and increasing their funding costs. Simultaneously, geopolitical anxieties are conveyed to banks via the actual economy. The impact of supply chain and commodity market disruptions on domestic economies, paired with inflation might compound banks’ market and credit losses, decreasing their profitability and capitalisation even more. The stress is likely to reduce banks’ risk-taking capabilities, leading them to restrict lending, and putting additional pressure on economic development.

The overall effect is disproportionately greater for banks in emerging markets and developing economies, as well as those with lower capitalisation ratios. Greater financial fragmentation as a result of geopolitical tensions could also disrupt capital flows and key economic and financial market indicators in the long run by limiting opportunities for international risk diversification, such as by reducing the number of countries in which domestic residents can invest.

Supervisors, regulators, and financial institutions have to invest significantly more resources to navigate the risks to financial stability posed by an increase in geopolitical tensions. Committing to identifying, quantifying, managing, and mitigating these dangers requires greater knowledge and monitoring of the linkages between geopolitical risks and traditional risks related to credits, interest rates, markets, liquidities, and operations. While both developed and developing nations have to amp up stress testing and scenario analysis to quantify the transmission of geopolitical shocks to their domestic financial institutions, generating actionable guidance becomes increasingly difficult as geopolitical crises often spiral out of control due to the interdependency of variables established over decades of industrial globalisation.

In response to increased geopolitical risks, economies that rely on external funding have to maintain a sufficient amount of international reserves, as well as capital and liquidity buffers at financial institutions. However, these economies heavily rely on exports for the inflow of foreign reserve currencies, and imports for access to manufacturing materials. To deal with possible financial instability caused by increased geopolitical tensions, policymakers also have to bolster crisis readiness and management frameworks. However, amidst geopolitical tensions, reliance on cooperation among national authorities to aid in the successful management and containment of international financial crises become weaker. As a result, the establishment of effective resolution mechanisms for financial institutions that operate across several jurisdictions becomes slow and unreliable.

During geopolitical crises, there is an increased need for mutual assistance agreements between countries to establish a global financial safety net – a system of organisations and processes that guarantee against crises and finance to minimise their damage. Regional safety nets, currency swaps, or fiscal mechanisms would be examples, as would precautionary credit lines from international financial institutions. Ideally, in the face of geopolitical risks, international regulatory and standard-setting bodies such as the Financial Stability Board and the Basel Committee on Banking Supervision should maintain efforts to promote common financial regulations and standards to avoid further financial fragmentation. However, whether the nations where the root of the crisis is grounded are receptive to proposed settlements, or have an influence on the global economy to an extent that such settlements become difficult to realise, remains uncertain. This was and continues to be heavily observed during the Russia-Ukraine conflict.


WHILE BOTH DEVELOPED AND DEVELOPING NATIONS HAVE TO AMP UP STRESS TESTING AND SCENARIO ANALYSIS TO QUANTIFY THE TRANSMISSION OF GEOPOLITICAL SHOCKS TO THEIR DOMESTIC FINANCIAL INSTITUTIONS, GENERATING ACTIONABLE GUIDANCE BECOMES INCREASINGLY DIFFICULT AS GEOPOLITICAL CRISES OFTEN SPIRAL OUT OF CONTROL DUE TO THE INTERDEPENDENCY OF VARIABLES ESTABLISHED OVER DECADES OF INDUSTRIAL GLOBALISATION.


After more than one year of Russia’s full-fledged invasion of Ukraine, the war’s economic impact is still felt around the world. While the war was not the primary cause of slower-than-expected economic growth in 2022 and revised estimates for 2023, it did have a detrimental impact on global economic activity, contributing to global inflationary pressures. The war has contributed to fluctuating and high commodity and energy costs, exacerbating food shortages and fueling inflation in many parts of the world. Although energy and grain prices have fallen since their peaks in mid-2022, the dangers of a price-hike comeback remain, and Europe may still confront energy security challenges.

Some of the war’s consequences have been reduced by targeted policy actions and initiatives, like the UN-mediated Black Sea Grain Initiative. Nonetheless, uncertainty about the duration and intensity of the conflict, as well as potential export limits in food-exporting countries, suggest that food supply issues will likely linger well into the end of 2023. Given the interruption to supply networks, countries have also taken precautions to ensure crucial imports. Given the cumulative experience with the COVID-19 epidemic and the crisis in Ukraine, it remains unclear whether global supply chains will change into radically different structures.

While initial estimates predicted a 10 to 15% contraction in the Russian economy, according to the most recent data from the Russian Federal State Statistics Service, the contraction over 2022 was significantly lower at 2.1%, as export earnings remained strong despite the war and a variety of sanctions. However, the Commonwealth of Independent States (CIS) and Georgia’s short-term economic prospects have been seriously harmed. Migration, commodity prices, market volatility, remittances, and changes in fiscal space have all been impacted. In the long run, the conflict’s political and economic ramifications are expected to continue impacting trade and finance flows in CIS countries, as well as the broader framework of their integration into the global economy.

The effect of geopolitical crises remains even after resolution. The World Bank estimated in September 2022 that the cost of rebuilding Ukraine would be around USD 411 billion, which is more than Ukraine’s pre-invasion GDP and three times more than all military, humanitarian, and financial assistance commitments to Ukraine since the beginning of the war. Rightfully, Ukraine has demanded compensation, but they are unlikely to be granted; instead, Russia continues to threaten Ukraine by staging preparations for a larger-scale battle. The ongoing Israel-Hamas conflict sees a similar unfolding of events, where each global leader demands and makes statements, while sentiments around the world; allies, hostiles and mediators, continue to get divided.


THE IMPACT OF GEOPOLITICAL CRISES, ESPECIALLY WAR, ALMOST ALWAYS RESULTS IN ENERGY SHORTAGES. RUSSIA’S PRINCIPAL ECONOMIC ENGAGEMENT WITH THE WEST WAS THROUGH OIL AND GAS EXPORTS. IT IS IMPROBABLE THAT THESE EXPORTS WILL BE RESTORED TO PRE-INVASION LEVELS.


Crises also determine the manner in which reconstruction proceeds. Both the Russia-Ukraine and Israel-Hasma conflicts have shown that most resolutions are only stopgaps such as repairs to restore power or water supply, humanitarian aides, temporary homes, or medical care. If the combat ceases but a still-dangerous frozen war results, private investors will remain hesitant until security assurances or recompense for damages are provided. Whatever funds are allocated for these nations end up being spent on military purposes.

The United States has given Ukraine more than USD 47.9 billion but nearly all of it has been in military and humanitarian help, while EU countries have offered the most cash assistance. Between January and November 2022, the United States contributed 0.23% of its GDP; Estonia and Latvia, nearly 1% each; and Poland 0.5%. In some ways, restoring Ukraine may be more expensive than fighting the war itself. The country has already sustained levels of damage not seen in Europe since World War II; it took Germany and the United Kingdom 20 to 30 years to rebuild after the war. A similar scenario is likely to unfold in Israel and the state of Palestine.

The impact of geopolitical crises, especially war, almost always results in energy shortages. Russia’s principal economic engagement with the West was through oil and gas exports. It is improbable that these exports will be restored to pre-invasion levels. Russia is still the world’s top supplier of wheat and forestry goods, as well as a source of vital resources including nickel, cobalt, and platinum. Whatever the outcome of the war, western corporations will be hesitant to return to Russia or invest there in the future. The dangers are simply too great. The current situation virtually recreates the Cold War division of the global economy in certain sectors; however, Russia is at a disadvantage because it no longer operates in the larger space of the Soviet bloc whose former members are now members of the EU and NATO.

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