Heightened global geopolitical risks stemming from escalating wars, simmering diplomatic tensions, and the persistent threat of terrorism increasingly unsettle financial markets, particularly in emerging economies.
The spring meetings of the IMF/World Bank Group are set to kick off next week, and the IMF’s flagship World Economic Outlook (WEO) and GSFR are scheduled to be released on Tuesday.
The inherent difficulty in pricing these unique and often abrupt events means that emerging markets, which are already more vulnerable, face a disproportionately more significant impact when geopolitical fault lines erupt.
Double effect on emerging markets
The IMF report chapter "Geopolitical Risks: Implications for Asset Prices and Financial Stability" reveals a clear correlation between increased geopolitical risk, measured by a surge in adverse news mentions, and a notable drop in stock prices.
Globally, the average monthly decline is around one percentage point during such periods.
However, this impact is significantly amplified in emerging market economies, where stock prices tend to fall by an average of 2.5 percent in such months.
The analysis further dissects the impact of different geopolitical events, revealing that international military conflicts hit emerging market stocks hardest, leading to an average monthly drop of five percent.
This is double the impact of other geopolitical events, likely due to the more severe economic disruptions associated with armed conflicts.
Pressure on public finances
Beyond equity markets, heightened geopolitical tensions also exert pressure on public finances.
As economic growth slows and government spending potentially increases due to conflict or instability, "sovereign risk premiums" – the cost of insuring against government default – tend to rise.
While advanced economies see an average increase of around 30 basis points, emerging market economies face a more significant jump of approximately 45 basis points.
In some vulnerable emerging markets, these premiums can surge up to four times as much, exacerbating existing financial strains.
The report also underscores the significant "cross-border spillovers" of geopolitical risks.
When a major trading partner becomes embroiled in an international military conflict, the stock valuations of other economies decline by an average of 2.5 percent.
Similarly, sovereign risk premiums increase when trading partners face geopolitical instability, with emerging market economies characterized by high public debt, low international reserves, and weak institutions particularly susceptible to these contagion effects.
A key transmission channel identified in the report is "heightened uncertainty."
Geopolitical shocks tend to elevate macroeconomic uncertainty for several months, prompting investors to demand a higher risk premium for holding assets perceived as more vulnerable during turbulent times.
This sudden drop in asset prices can cascade through the financial system, negatively impacting banks through reduced lending and investment funds through lower returns and increased redemption risks.
Required proactive measures
In light of these findings, the IMF report emphasizes the importance of proactive measures to mitigate the impact of geopolitical risks on financial stability.
It urges financial institutions and their regulators to dedicate sufficient resources to identifying, quantifying, and managing these unique risks through stress tests and scenario analysis.
Furthermore, financial institutions should maintain adequate capital and liquidity buffers to absorb potential losses.
The report also stresses the need for emerging markets and developing economies to develop and deepen their financial markets, which would provide investors with better tools for managing risk.
Countries with weaker fiscal policy space and inadequate international reserves are identified as particularly vulnerable to geopolitical shocks, highlighting the importance of building these buffers to enhance resilience against future disruptions.
The findings of this IMF analysis serve as a stark reminder of the significant and often underestimated impact of global geopolitical instability on the fragile financial landscapes of emerging market economies.
As the world grapples with increasing tensions, policymakers and investors in these regions must prioritize proactive risk management and strengthen economic and financial buffers to weather the inevitable storms.
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