The Interaction between Geopolitics and Financial Markets: Geofinance


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By Pascal vander Straeten May 01, 2023

Global market reactions can be significantly or persistently influenced by geopolitical events, as we all know. For example, when a naval war causes a price increase in commodities, or when a terrorist plague leads to reduced appetite for investments and consumption in the long term. Although geopolitical events receive extensive media coverage, most of them do not result in significant or persistent market reactions. Financial markets tend to be relatively complacent about geopolitics unless there is a large spike in volatility.

However, geopolitical events can be triggered by market events, which is less well known. It is not difficult to see this in the 2010 eurozone crisis, particularly the Grexit, where Athens would have turned to Moscow for help if Greece had defaulted (thereby leaving NATO and weakening its southern flank). Since Greece has long been an anchor for the Western world against external threats, its departure from European institutions, or even a substantial weakening of its polity, would exacerbate threats to the Balkans, the Southern Mediterranean and the Eastern Mediterranean at a time when tensions are arguably at their highest.

Mining and energy producers can also be affected by a fall in commodity (and energy) prices. There are the largest concentrations of oil-dependent economies in the Middle East and North Africa, for example. Nearly a third of seaborne crude oil and liquefied natural gas exports come from the region. OPEC production and exports are also concentrated in the Middle East – specifically the Persian Gulf. Libya’s production fluctuations show that the Middle East is the region most exposed to volatility in global energy markets. Following the turmoil of the Arab Spring, a sustained drop in oil prices could threaten the economic stability of many of the region’s energy exporters.

Chinese officials are seeking ways to deflect popular anger from domestic ills and channel it into nationalistic overseas ambitions to counter the economy’s apparent weakness. Outsiders tend to portray China as a country that is quite different from what it is – an emerging superpower with global economic reach and ambitions to challenge American dominance, at least in Asia. China’s real, familiar face is facing serious, long-term problems at home. China’s international ambitions diverts us from the reality that China’s leaders must cope with social, political, economic, and environmental problems on a scale that demands a significant share of the country’s resources and prestige. In essence, these overseas adventures expose China’s weaknesses and vulnerabilities, and underscore the leadership’s insecurity when it comes to dealing with them. And this makes China’s neighbors very nervous.

Traditionally, geopolitics has focused on foreign policy, military might, resources, and demographics as measures of national influence, whereas finance focuses on funding activities, trading financial securities, commodities, and other fungibles of value at low transaction costs and at prices that reflect supply and demand.

It has been defined by geofinance that geopolitics and finance interact. There is no doubt that geopolitics and finance have been intertwined throughout history. Historically speaking, tail risk already loomed large in financial markets before the end of the Cold War (the 1980s) as well as in the decade following the end of the Cold War.

While the world has become a global village because of faster communication channels, (relatively) free capital movements, and more efficient logistics, tail events, whether driven by geopolitics, financial market disruption, or a combination of both, have always been a common occurrence in this same world.

A more contemporary example of the nexus between geopolitics and finance would be the eurozone crisis and its connection with the power games between Moscow and Washington. For example, in 2014, Germany needed a deal with Russia (Crimean crisis) to deal with the existential crisis for the eurozone (Grexit and the domino effect); Russia needed a deal with the United States to limit the U.S. encroachment on its sphere of influence (the reason the U.S. never sent heavy military assets to Kiev); and the United States needed a deal with Iran to refocus its attention on Russia. After the Cold War, an era of common norms ended; now, close to 30 years after the fall of the Berlin Wall, strategic competition is returning. Geopolitics and finance are experiencing a seemingly accelerating dynamic. It involves new players and takes place in a context of deep financial integration. Realpolitik today is not ideologically driven.

Could geopolitics undermine global finance, international markets, and the win-win logic of finance? What impact will financial decisions and spheres of influence have on the global balance of power? When countries use financial tools rather than military tools to advance their interests, what global risks could arise?

Several trends have brought these questions to light, including:

  • As tensions in East Asia have risen recently, there has been an acceleration of regional integration in South-East Asia and a rise of alternative financial markets and tools in general.
  • Middle Eastern great power games and Ukrainian conflict,
  • Latin American integration mechanisms compete,
  • Asserting China’s leadership in the global banking industry
  • As a result of terrorism and violent strife, borders are being redrawn and financial markets are slipping backwards.

The increasing speed of information transmission and global interconnectedness have strengthened the connection between geopolitics and finance, with cyberspace representing an important new front in the geopolitical equation since cyber-attacks are becoming increasingly dangerous.

The lack of predictability of sanctions and other instruments of financial coercion increases the risk of unintended consequences for decision-makers. A few public policy and international cooperation areas are affected by the interplay between geopolitics and finance. Governments and businesses should conduct “geopolitical due diligence” to avoid being caught off guard. There are three areas where direct effects are likely – disruptions to international finance, threats to political cooperation, and the international rules-based system (through prudential regulation).

Financial markets and investment flows are being impacted by the growing direct role of the state in global finance, which is increasing the interplay between finance and geopolitics, and potentially enabling countries to exert geopolitical influence through financial dependence.

This trend is manifested in increasing state-led investments in other countries’ infrastructure, such as (i) Chinese investment in Africa or Latin America; (ii) strategic investments by sovereign wealth funds and state-owned enterprises in land and businesses in other countries, as seen with Gulf economies’ investments in Africa; and (iii) government purchases of other governments’ debts.

To strengthen their geopolitical position, countries have also taken measures to control access to financial resources or the prices of commodities over which they exert monopoly power, thereby hurting the performance of other financial economics. Foreign policy is increasingly thinking about how to leverage power over other countries through financial economic links.

It is possible for unintended effects on other countries to spill over into geopolitical spheres when countries concentrate on their domestic/regional market – even if the decisions are taken by central banks rather than politicians. In recent years, Japan’s expansionary monetary policies have resulted in a 50% devaluation of the yen because of its expansionary monetary policies to restart its domestic economy, much to the detriment of its neighbors, while quantitative easing has affected foreign capital flows into emerging markets.

Under the guise of policies intended to reduce risk, countries often revert to protectionism when faced with political and financial volatility at home. Different forms of protection exist. State bailouts, for example, can be related to the protection of strategic sectors or local content requirements.

Russian and Western sanctions are other punitive geofinancial measures, such as tit-for-tat, which indicates that some countries are willing to endure a long period of economic hardship and diplomatic woe to achieve their political objectives.

Punitive geofinancial measures may lead to a growing number of countries protecting their own markets, such as the recent BRICS initiative about a common currency for trade and payments. Global capital flows could be significantly affected by this. Financial consequences of sanctions include fiscal pressures, slow growth, and unemployment. In advanced and emerging economies, the slowdown in globalization, the rise in protectionism, and the increasing prevalence of sanctions could lead to slower growth. The failure to meet the aspirations of large portions of the population could result in social unrest and political instability in emerging economies.

The Bretton Woods institutions (World Bank and IMF) play a major role in interplay between finance and geopolitics. To reduce global imbalances, countries have been unable to agree on an institutionalized, closer coordination of fiscal policies. In an era defined by erosion of trust, the failure to mitigate these imbalances, combined with the return of strategic competition, raises the tail-risk of undermining the Bretton Woods institutions themselves and the international rule-based system.

Alternative structures have been established in several countries to reflect these developments. Brazil, Russia, India, and China created the New Development Bank, also known as the BRIC Bank, which plans to lend up to $34 billion worldwide. In the vein, China and 20 other countries founded the Asian Infrastructure Investment Bank. Even though a retreat from global multilateralism is alarming, stronger regional multilateralism may not necessarily be a bad thing, since regional solutions to regional problems can be consistent with global governance.

Reducing the barriers to international collaboration is crucial at a time when interconnected challenges can only be addressed by global cooperation. To reduce the risk of negative effects of geoeconomic measures, what can stakeholders do to strengthen international collaboration? Due to a growing trend of governments looking inward and prioritizing their domestic/regional markets and competing strategic pivots, and a greater reliance on financial levers to gain geopolitical influence, competing relationships between major powers are likely to evolve into currency and finance wars in the coming years, requiring geofinancial diplomacy.

If you want to read more about geofinance, I recommend this book: “An Overture to Geofinance: Global Finance, Geopolitics, and the Wielding of Power: Theory and Praxis” and this link



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