Geopolitical risk fragments capital flows, hinders risk-sharing

The paper analyzes bilateral official lending data from 1910 to 2024, revealing how geopolitical risk shapes capital allocation.

It documents that during periods of high geopolitical tension, such as the two World Wars and parts of the Cold War, bilateral lending increasingly flows towards geopolitically aligned countries.

This trend, termed 'financial fragmentation', has intensified again since Russia's invasion of Ukraine in early 2022.

A 10% increase in geopolitical risk is associated with a 1.5 percentage point rise in fragmentation, an effect that persists for over a decade.

This shift is most pronounced in official government-to-government lending, less so in private flows, and largely absent in multilateral official lending.

The study highlights that politically aligned countries tend to experience more synchronized business cycles and correlated macroeconomic tail risks, meaning that lending to allies connects economies that are likely to face adverse shocks simultaneously.

This significantly weakens the risk-sharing properties typically observed in international capital flows.

To explain these empirical patterns, the authors develop a limited-commitment model of sovereign borrowing with geopolitical considerations.

The model features a "geopolitical externality," where the home country places a negative weight on the rival bloc's welfare, influencing default incentives even with non-discriminatory default across creditors.

Higher geopolitical tensions, modeled as increased disutility from the rival, shrink the borrowing set and tilt feasible portfolios towards the allied bloc.

This mechanism endogenously generates financial fragmentation, which can be partial (reduced rival borrowing) or complete (no cross-bloc lending).

Consequently, this leads to a decline in international risk-sharing, aligning with the empirical findings.