According to a latest blog post from the International Monetary Fund or IMF, global geopolitical risks remain elevated, raising concerns about their potential impact on economic and financial stability. Shocks such as wars, diplomatic tensions, or terrorism can disrupt cross-border trade and investment. This can hurt asset prices, affect financial institutions, and curtail lending to the private sector, weighing on economic activity and posing a threat to financial stability. Such risks are challenging for investors to price due to their unique nature, rare occurrence, and uncertain duration and scope.
This can lead to sharp market reactions when geopolitical shocks materialize. IMF researchers Salih Fendoglu, Mahvash S. Qureshi, Felix Suntheim noted that stock prices tend to decline significantly during major geopolitical risk events, as measured by more frequent news stories mentioning adverse geopolitical developments and associated risks. The average monthly drop is about 1 percentage point across countries, though it’s a much larger 2.5 percentage points in emerging market economies.
Heightened geopolitical risks may also affect the public sector as economic growth slows and governments spend more. Consequently, sovereign risk premiums—measured by prices for credit derivatives that protect against default—often increase after geopolitical events by, on average, about 30 basis points for advanced economies and 45 basis points for emerging market economies. Geopolitical risk events can also spill over to other economies through trade and financial linkages, increasing the risk of contagion. Stock valuations decline by an average of about 2.5 percent following the involvement of a main trading partner country in an international military conflict.
The blog post noted that financial institutions and their regulators should allocate adequate resources to identify, quantify, and manage geopolitical risks. For example, through stress tests and other analyses that incorporate how such risks are likely to interact with financial markets. Emerging market and developing economies should further develop and deepen financial markets to help investors manage risks.
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