Geopolitical tension and economic fragmentation threaten financial stability, IMF says

Rising geopolitical tensions and geo-economic fragmentation are posing serious threats to global financial stability, redirecting cross-border investments and hitting emerging markets the most, the International Monetary Fund has warned.

The world could lose nearly 2 per cent of its output in the long term as investors re-divert foreign direct investment flows in line with geopolitical preferences, the Washington-based lender said in its World Economic Outlook report.

“These losses are likely to be unevenly distributed. Emerging market and developing economies are particularly affected by reduced access to investment from advanced economies, due to reduced capital formation and productivity gains from the transfer of better technologies and know-how,” IMF economists said in a related blog post on Wednesday.

“A fragmented world is likely to be a poorer one.”

In January, the IMF raised its global economic growth estimate for this year by 0.2 percentage points to 2.9 per cent from its October forecast, but cautioned that the financial environment remains “fragile”.

The same month, it also said that severe fragmentation of the global economy after years of increasing economic integration could reduce global economic output by up to 7 per cent.

Its latest warning comes amid growing concerns about the effect of strained ties between the US and China since 2016, and the Russia-Ukraine war, which has been continuing for more than a year.

Escalating geopolitical tensions have tested international relations, raised doubts about the benefits of globalisation and split the world into increasingly fragmented trading blocs.

“If geopolitical tensions continue to intensify and countries further diverge along geopolitical fault lines, FDI may become even more concentrated within blocs of aligned countries,” the IMF said on Wednesday.

Emerging market and developing economies are more vulnerable to FDI relocation than advanced economies, partly because they rely more on flows from more distant countries, although advanced economies are also not immune, the fund said.

Companies and policymakers are also increasingly trying to make supply chains more resilient by moving production to their home nations or friendly countries.

While this could strengthen national security and help maintain a technological advantage over geopolitical rivals, it can also often reduce diversification and make countries more vulnerable to macroeconomic shocks, the IMF said.

Mounting geopolitical tensions could set off cross-border capital outflows and increased uncertainty that would threaten the world's financial stability, the multilateral lender said.

Financial fragmentation along geopolitical lines has “important implications” by affecting cross-border investment, international payment systems and asset prices, it said.

This fuels instability by increasing banks’ funding costs, lowering their profitability and reducing their lending to the private sector.

Heightened tensions between an investing nation and a recipient country can reduce overall bilateral cross-border allocation of portfolio investment and bank claims by about 15 per cent, according to IMF estimates.

Investment funds are especially sensitive to geopolitical tensions and tend to reduce their cross-border allocations notably to countries with a diverging foreign policy outlook, the fund said.

Geopolitical tensions could threaten financial stability through multiple channels.

“Imposition of financial restrictions, increased uncertainty, and cross-border credit and investment outflows triggered by an escalation of tensions could increase banks’ debt rollover risks and funding costs,” the IMF said.

“It could also drive-up interest rates on government bonds, reducing the values of banks’ assets and adding to their funding costs.”

Meanwhile, conflict-related disruptions to supply chains and commodity markets can affect domestic economic growth and inflation. This can worsen banks' market and credit losses, further reducing their profitability and capitalisation, the IMF said.

This is likely to reduce banks' risk-taking ability, prompting them to cut lending and further weighing on economic growth.

The overall effect will be “disproportionately larger” for lenders in emerging markets and developing economies, and for those with lower capitalisation ratios, the IMF said.

“In the longer run, greater financial fragmentation stemming from geopolitical tensions could also roil capital flows and key economic and financial market indicators by limiting the possibilities for international risk diversification, such as by reducing the number of countries in which domestic residents can invest,” it said.

Given such risks, “policymakers should be aware that imposing financial restrictions for national security reasons could have unintended consequences for global macro-financial stability”, the fund said.

“Multilateral efforts should be strengthened to reduce geopolitical tensions and economic and financial fragmentation.”

To ease the impact of geopolitical shocks on financial systems, the IMF recommended that policymakers ensure an adequate level of international reserves, capital and liquidity buffers at financial institutions.

The global financial safety net — a set of institutions and mechanisms that insure against crises and provide financing to mitigate their impact — must be reinforced through mutual assistance agreements between countries.

Efforts by international banking and financial regulatory bodies should also continue to promote common financial regulations and standards to prevent an increase in financial fragmentation, the IMF said.

“The estimated large and widespread long-term output losses show why it’s crucial to foster global integration — especially as major economies endorse inward-looking policies,” it said.

“At the same time, the current rules-based multilateral system must adapt to the changing world economy and should be complemented by credible mechanisms to mitigate spillovers from unilateral policy actions.”