Fiscal stability and geopolitical risk

Geopolitics is – unfortunately – an increasingly important driver of financial markets and government finances. The Russian invasion of Ukraine and the War in Gaza are just two hot spots that have increased the need for governments to spend on arms and munitions. If geopolitical risks remain elevated in the coming years, it is probably a good idea to investigate what this means for government finances.

A team from the Lisbon School of Economics and Management used the Geopolitical Risk Index by Dario Caldara and Matteo Iacovello to estimate how increasing geopolitical risk impacts both the budget deficits of countries as well as their trade balance. We know from the original research on the Geopolitical Risks Index that higher levels of geopolitical risk reduce investment because uncertainty is always bad for business. Heightened geopolitical risks often come with the risk of war or civil strife, so why invest if your machinery and factories may soon be blown to smithereens?

Interestingly, the Lisbon team looked exclusively at European countries between 2001 and 2022, which is a group of countries with very little exposure to geopolitical risk. The chart below shows that the only major spikes in geopolitical risks during that time were the 9/11 terror attacks, the start of the War in Iraq, the London Bombings, the Russian invasion of Ukraine and the Bataclan terror attacks in France in late 2015.

Geopolitical Risk Index for major European countries

Source: Caldara and Iacovello (2022)

But even in this relatively benign environment, there is a clear connection between geopolitical risks, budget deficits and trade balances. When geopolitical risks increase, the reduction in investment activity as well as the general increase in uncertainty tends to reduce GDP growth and more importantly tax revenues, creating a larger fiscal deficit for the government. This negative impact on government budgets is significantly larger if the country is already in recession or suffering from a weak economy when the geopolitical shock hits.

This is why the Russian invasion of Ukraine hit Germany and the UK so hard in 2022. These countries were still in the recovery process from the pandemic when gas prices spiked. On top of that, most European countries committed to large military and civil aid for Ukraine which increased government expenditure.

Additionally, trade balances tend to significantly deteriorate when geopolitical risks rise. A country that is under stress at home tends to export less and import more. The result is that trade surpluses shrink while trade deficits increase. And this effect is large. It is about three to six times larger than the impact on the government budget deficit and it tends to spill over to neighbouring countries because these tend to have the closest trading relationships. So, when France’s trade balance declined after the Paris terror attacks, Germany, Spain, and Switzerland, all felt a little bit of that pain as well.

Now, the elephant in the room for the coming decade is Europe’s relationship with the US and China. The tensions between China and the West are ratcheting higher all the time and the geopolitical risks from a potential military standoff in the South China Sea would be enormous. This would inevitably call for massive defence spending and indeed Europe is already increasing its defence spending significantly. But this comes at a price, the price of higher government deficits and increased risks of a bond market fallout like the UK has seen under Prime Minister Liz Truss in 2022. Certainly, the future is not going to be boring…

US-China Tensions Index

Source: Rogers et al. (2024)