## CHAPTER 3 GEOPOLITICS ANd FINANCIAL FRAGMENTATION: IMPLICATIONS FOR MACRO-FINANCIAL STABILITY

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### Chapter 3 at a Glance — Key findings
- Rising geopolitical tensions among major economies have intensified concerns about global economic and financial fragmentation.
- Financial fragmentation induced by geopolitical tensions could affect cross-border allocation of capital, international payment systems, and asset prices, with important implications for global financial stability.
- Quantified effects on cross-border allocation:
  - A one-standard-deviation increase in geopolitical tensions between an investing and a recipient country—equivalent to the diverging voting behavior of the United States and China in the United Nations since 2016—could reduce bilateral cross-border portfolio and bank allocation by about 15 percent.
  - Investment funds’ cross-border portfolio allocations decline by more than 20 percent for a one-standard-deviation increase in geopolitical distance.
- Country- and episode-specific outcomes:
  - After Russia’s invasion of Ukraine and subsequent sanctions, cross-border banking and portfolio debt flows to Russia and its allies have reversed sharply, with allocations falling by about 20 and 60 percent relative to prewar levels, respectively.
- Macro-financial transmission and vulnerabilities:
  - Reversals could increase banks’ funding costs, reduce their profitability, and lower their provision of credit to the private sector.
  - Impacts are disproportionately larger for banks with lower capitalization ratios.
  - Greater financial fragmentation can reduce international risk diversification opportunities and exacerbate macro-financial volatility.
  - Economies with less developed financial systems or inadequate external buffers are more vulnerable to geopolitical shocks.
- Geopolitical factors are already influencing trade and capital allocation; restrictions on cross-border capital flows have increased as geopolitical tensions have risen.

### Conceptual framework — transmission channels and feedbacks
- Two key transmission channels:
  - Financial channel:
    - Restrictions on capital flows and payments (capital controls, financial sanctions, international asset freezing).
    - Increased uncertainty and investor risk aversion to future restrictions, conflict escalation, or expropriations.
    - Mechanisms: cross-border reallocation of credit and investments leading to sudden capital flow reversals; disruption in cross-border payments; cuts to cross-border credit lines.
    - Direct outcomes: decline in asset prices, higher funding costs, debt rollover risk, reduced asset values and profitability in financial and nonfinancial sectors, liquidity and solvency stress.
  - Real channel:
    - Restrictions on international trade and technology transfer; supply chain and commodity-market disruptions.
    - Mechanisms: lower international trade and economic growth; inflationary pressures.
    - Indirect outcomes: reduced liquidity and profitability of nonfinancial corporations; credit risks for banks.
- Reinforcing feedbacks:
  - Adverse loops between financial and real channels (for example, trade restrictions reduce output → discourage cross-border investment → further weaken activity and trade interlinkages).
  - Commodity market disruptions → higher inflation → monetary tightening → lower asset prices and higher borrowing costs → financial stability risks.
- Additional channels: increased cybersecurity, compliance, legal, reputational risks; fragmentation of commodity markets; impediments to international cooperation on climate change; risks to debt restructuring/cooperation.

### Empirical and measurement notes on geopolitical metrics
- Geopolitical distance measurement:
  - Measured using divergence in countries’ voting behavior in the UN General Assembly (Häge 2011 measure; based on the “S” measure in Signorino and Ritter 1999).
  - Sensitivity checks use alternative UN voting measures (Häge 2011; Bailey, Strezhnev, and Voeten 2017) and proxies such as bilateral financial sanctions and arms trade.
  - Correlation between geopolitical distance measures from Häge (2011) and Bailey, Strezhnev, and Voeten (2017) ranges from 0.6 to 0.9.
  - Likelihood of imposing financial sanctions is significantly higher for country pairs that are more geopolitically distant.

### Implications of fragmentation and cross-country heterogeneity
- Financial fragmentation effects:
  - Limits diversification of international assets and liabilities, increasing vulnerability to shocks.
  - Can increase long-term volatility of capital flows and domestic asset returns.
- Country-specific asymmetries:
  - Impact depends on financial interconnectedness, level of financial development, and size of external buffers.
  - Currencies widely held as international reserves may face shifts in foreign official investor preferences toward reserve assets of geopolitically aligned countries.
  - Reallocation toward geopolitically aligned financing could improve continuity of external finance in some cases, conditional on absorptive capacity and policy frameworks.
- Cross-border spillovers:
  - Losses at financial institutions, withdrawal of credit lines, asset price declines, high inflation, and slowdown in activity can spill over beyond directly involved countries.
  - Spillovers are larger when tensions involve major, globally integrated economies.
  - Neutral countries might attract reallocated capital, conditional on absorptive capacity and policies.

### Historical and recent developments in global financial integration — select findings
- Broad trends:
  - Total external financial assets and liabilities expanded rapidly in the 1990s and through most of the 2000s.
  - Momentum slowed after the global financial crisis; capital flows relative to output have been well below precrisis peaks in advanced economies and in emerging market and developing economies.
- Drivers of reduced cross-border capital movements:
  - Decline in banking flows due to retrenchment of global banks from foreign jurisdictions.
  - Increasing use of official restrictions on capital flows; capital account restrictions on inflows and outflows have increased notably since the global financial crisis.
  - Correspondent banking relationship reductions, particularly in developing economies, and regulatory changes affecting banks also contributed.
- Capital account restrictiveness:
  - Capital account restrictions have increased since the global financial crisis and are now almost as prevalent as the levels observed in the early 1990s in both advanced economies and emerging market and developing economies.
  - Note: measures capture presence of restrictions but not intensity; earlier-period restrictions may have been more severe.
- Shifts in global financial roles:
  - The United States continues to dominate global debt and portfolio equity investment; its share in foreign direct investment has declined.
  - China and several international financial centers (such as Ireland and Luxembourg) have grown in importance, with notable increases in their holdings of external assets.
- Bilateral interlinkages and concentration:
  - Bilateral financial interlinkages have weakened in recent years; cross-border investment has become more concentrated in fewer partner countries.
  - Cross-border financial exposures are increasingly concentrated in major advanced and emerging market economies.
- Geopolitics and capital allocation:
  - Geopolitical affinities (UN voting similarity) matter for cross-border capital allocation; recent data suggest weakening financial ties between the United States/Europe and Russia, and mixed trends for China with the United States and other major advanced economies.

### Quantitative effects on portfolio, banking, and aggregate flows
- Bilateral and aggregate effects:
  - A one-standard-deviation increase in geopolitical distance between a source and a recipient country is associated with about a 15 percent reduction in bilateral cross-border allocation of portfolio investment and bank claims.
  - Investment funds’ cross-border portfolio allocations decline by more than 20 percent for a one-standard-deviation increase.
- Aggregate and country-level magnitudes:
  - If geopolitical distance between a recipient country and all partner countries with which it already has little agreement on foreign policy issues were to increase by one standard deviation:
    - the median (mean) gross portfolio investment outflow would be equivalent to 1.5 (2.8) percent of the recipient country’s GDP.
    - the decline in portfolio flows could amount to about 3 percent of world GDP.
    - the median (mean) decline in cross-border banking flows would be 0.3 (1) percent of recipient country GDP.
- Alternative measures and sanctions effects:
  - A decline of one standard deviation in bilateral arms trade is associated with a 4–5 percent decline in equity portfolio investments and banking claims to the recipient country.
  - Imposing financial sanctions could reduce remittance volume to the sanctioned country by about 17.1 percent within six quarters while increasing the cost of remittances (fees and foreign exchange margins) by 3 percentage points.
- Aggregate (weighted-average) effects on net capital flows:
  - An increase of one standard deviation in geopolitical distance with a country’s financial partners is associated, on average, with a decline in net capital flows of about 3 percent of GDP for emerging market economies and about 2 percent of GDP for advanced economies.
  - For emerging market economies, a large portion of the total effect on net capital flows corresponds to a decline in portfolio flows.

### Banks, lending, and financial stability — empirical bank-level results
- Data and approach:
  - Panel regressions on more than 5,000 banks from 52 economies.
  - Effects estimated for a one-standard-deviation increase in geopolitical distance; regressions include interaction with a high-distance dummy (above the 75th percentile).
- Main bank-level outcomes after increased geopolitical distance to foreign lenders:
  - Significantly increased banks’ funding costs (measured as total interest expenses-to-total interest-bearing liabilities, percentage points).
  - Reduced profitability ((log) Operating profits-to-total assets, percent).
  - Contracted lending ((log) Real outstanding gross loans, percent).
  - Effects are larger for emerging market and developing economies.
- Nonlinearity and capitalization interaction:
  - Overall effects—particularly on banks’ lending—tend to be larger when tensions in relation to foreign lenders are already elevated.
  - “High capital ratio” corresponds to banks with equity-to-total assets ratio above the 75th percentile of banks in a given country in a given year.
  - Banks with relatively lower capital ratios experience a greater increase in borrowing costs, a larger decline in profitability, and a larger decline in lending than better-capitalized banks.
  - Implication: building bank capital buffers can mitigate transmission of geopolitical shocks to the real economy.

### Remittances and cross-border payment disruptions — key statistics
- Remittances as external income:
  - On average, remittances amount to about 2.5 percent of GDP, but in some cases more than 26 percent.
  - G20 commitment: reduce the global average remittance cost to 5 percent; UN SDG target: 3 percent by 2030.
- Recent trends and sanction effects:
  - The average cost of sending remittances (weighted by the volume of remittances) to Eastern Europe and Central Asia surged by 27.4 percent between the end of 2021 and the second quarter of 2022.
  - Formal analysis of financial sanctions on remittances in 18 countries from the first quarter of 1980 to the second quarter of 2022 finds:
    - Financial sanctions increase the cost of sending remittances (measured as a percentage of the remitted amount) to sanctioned countries by 3 percentage points.
    - The volume of remittances drops by 17.1 percent after six quarters of sanctions.
- Chart and panel notes referenced in the source:
  - Chart scales and panel time labels are reported as presented (for example, scales –30 to 30 Percent; –50 to 10 Percent; horizontal axis t+1+2+3+4+5+6 for quarters after sanctions).

### Financial fragmentation, volatility, and welfare — model scenarios and quantified impacts
- Model and scenarios:
  - Two-country open‑economy model with trade in stocks and bonds calibrated to G7 economies and a rest‑of‑world sample of 53 countries (based on Coeurdacier, Kollmann, and Martin 2010).
  - Fragmentation scenarios for each G7 economy:
    - Full integration: G7 trade with rest of world.
    - Moderate fragmentation: unable to engage in financial transactions with countries whose geopolitical distance measure lies in the top 25th percentile.
    - Extreme fragmentation: unable to engage with countries whose geopolitical distance measure lies in the top 50th percentile.
    - Autarkic scenario: G7 economies financially cut off from all other economies.
- Quantified changes in median volatility (relative to full integration):
  - Output: increases by 1 and 3 percentage points under the “moderate” and “extreme” fragmentation scenarios, respectively.
  - Real consumption, corporate profits, equity and bond prices: increases in the range of 2–8 percentage points under fragmentation scenarios.
  - Full integration = 100 (median volatility (standard deviation) under fragmentation scenarios shown in the source).
- Loss of diversification benefits:
  - “Moderate” fragmentation implies about 20 percent of diversification benefits from financial integration would be lost.
  - “Extreme” fragmentation implies nearly 40–50 percent of the benefits would be lost.
- Caveats:
  - Simulations focus only on loss of cross‑border investment diversification benefits and assume full substitutability of foreign goods production among trading partners.
  - Alternative assumptions or broader geoeconomic fragmentation affecting trade, technology diffusion, and labor migration could impose additional costs.
  - Simulations do not account for potential benefits from fragmentation (for example, capital reallocation) or whether fragmentation reduces threats to national or global security.

### Policy recommendations — oversight, buffers, cooperation
- Strengthen Financial Oversight:
  - Supervisors, regulators, and financial institutions should identify, quantify, manage, and mitigate risks from a potential rise in geopolitical tensions.
  - Geopolitical risks and their transmission mechanisms should be formally embedded in stress-testing frameworks and scenario analysis (including through the Internal Capital Adequacy Assessment Process).
- Build Adequate Buffers and Safety Nets:
  - Economies reliant on external financing should ensure an adequate level of international reserves as well as capital and liquidity buffers at financial institutions.
  - Transmission of geopolitical shocks should be considered in quantification of credit, interest rate, market, liquidity, and operational risks; buffers should be calibrated to protect against extreme but plausible losses associated with tail risk.
  - Strengthen crisis preparedness and management frameworks, and maintain cooperative arrangements for effective management and containment of international financial crises, including resolution mechanisms for cross-border institutions.
  - Mutual assistance agreements—through regional safety nets, currency swaps, or fiscal mechanisms—could help smaller countries weather shocks; demand for global financial safety nets will increase.
  - The IMF could play a role through financing facilities, particularly the precautionary lending toolkit, and through policy advice and capacity development.
- Strengthen International Cooperation:
  - International regulatory and standard-setting bodies should continue promoting convergence in financial regulations and standards to prevent increased financial fragmentation.
  - Deepen international cooperation to improve cross-border payments and develop frameworks to enhance interoperability of payment systems to mitigate disruptions.
  - Policymakers should weigh national security–driven financial restrictions against potential global macro-financial stability risks, including financial fragmentation, higher inflation, lower global growth, and financial contagion, and pursue diplomacy to prevent escalation of geopolitical tensions.

*Source: IMF staff; CHAPTER 3 GEOPOLITICS ANd FINANCIAL FRAGMENTATION: IMPLICATIONS FOR MACRO-FINANCIAL STABILITY (April 2023).*

### Chapter 3 at a Glance

### Chapter 3 at a Glance

### Key findings
- Rising geopolitical tensions among major economies have intensified concerns about global economic and financial fragmentation.
- Financial fragmentation induced by geopolitical tensions could have potentially important implications for global financial stability by affecting the cross-border allocation of capital, international payment systems, and asset prices.
- Geopolitical tensions, proxied by the divergence in the foreign policy orientation of investing and recipient countries, matter significantly for cross-border portfolio allocation.
  - A one-standard-deviation increase in geopolitical tensions between an investing and a recipient country—equivalent to the diverging voting behavior of the United States and China in the United Nations since 2016—could reduce bilateral cross-border portfolio and bank allocation by about 15 percent.
- An increase in geopolitical tensions with major partner countries could cause a sudden reversal of cross-border capital flows, with the effect being more pronounced for emerging market and developing economies than for advanced economies.
  - After Russia’s invasion of Ukraine and subsequent sanctions, cross-border banking and portfolio debt flows to Russia and its allies have reversed sharply, with allocations falling by about 20 and 60 percent relative to prewar levels, respectively.
- Such reversals could pose macro-financial stability risks by:
  - increasing banks’ funding costs,
  - reducing their profitability,
  - lowering their provision of credit to the private sector.
  - These impacts are likely to be disproportionately larger for banks with lower capitalization ratios.
- Greater financial fragmentation stemming from geopolitical tensions could also exacerbate macro-financial volatility in the longer term by reducing international risk diversification opportunities in the face of adverse domestic and external shocks.
- Economies with less developed financial systems or inadequate external buffers may be more vulnerable to geopolitical shocks because of limited capacity to absorb adverse consequences.
- Geopolitical factors appear to be already influencing international trade and capital allocation; restrictions on cross-border capital flows have increased as geopolitical tensions have risen.

### Policy recommendations
- Policymakers need to be aware of potential financial stability risks associated with a rise in geopolitical tensions and devote resources to their identification, quantification, management, and mitigation.
- To develop actionable guidelines for supervisors, a systematic approach that employs stress testing and scenario analysis is needed to assess and quantify geopolitical shock transmission to financial institutions.
- Based on the assessments of geopolitical risks, banks and nonbank financial institutions may need to hold adequate capital and liquidity buffers to mitigate the adverse consequences of rising geopolitical risks.
- In the face of rising geopolitical tensions, the adequacy of the global financial safety net needs to be ensured through:
  - strong levels of international reserves held by countries,
  - bilateral and regional financial arrangements,
  - precautionary credit lines from international financial institutions.
- Given the significant risks to global macro-financial stability, countries should make utmost efforts to strengthen engagement and dialogue to diplomatically resolve geopolitical tensions and prevent economic and financial fragmentation.

*Chapter authors: Mario Catalán (co-lead), Max-Sebastian Dovì, Salih Fendoglu, Oksana Khadarina, Junghwan Mok, Tatsushi Okuda, Hamid Reza Tabarraei, Tomohiro Tsuruga (co-lead), and Mustafa Yenice, under the guidance of Fabio Natalucci and Mahvash Qureshi. Luigi Zingales served as an expert advisor.*

### CHAPTER 3 GEOPOLITICS ANd FINANCIAL FRAGMENTATION: IMPLICATIONS FOR MACRO-FINANCIAL STABILITY

### CHAPTER 3 GEOPOLITICS ANd FINANCIAL FRAGMENTATION: IMPLICATIONS FOR MACRO-FINANCIAL STABILITY

### Conceptual framework: channels through which geopolitical tensions affect macro-financial stability
- Two key transmission channels:
  - Financial channel
    - Restrictions on capital flows and payments (capital controls, financial sanctions, international asset freezing).
    - Increased uncertainty and investor risk aversion to future restrictions, conflict escalation, or expropriations.
    - Mechanisms: cross-border reallocation of credit and investments leading to sudden capital flow reversals; disruption in cross-border payments; cuts to cross-border credit lines.
    - Direct outcomes: decline in asset prices, higher funding costs, debt rollover risk, reduced asset values and profitability in financial and nonfinancial sectors, liquidity and solvency stress.
  - Real channel
    - Restrictions on international trade and technology transfer; supply chain and commodity-market disruptions.
    - Mechanisms: lower international trade and economic growth; inflationary pressures.
    - Indirect outcomes: reduced liquidity and profitability of nonfinancial corporations; credit risks for banks.
- Reinforcing feedbacks
  - Adverse loops between financial and real channels (for example, trade restrictions reduce output → discourage cross-border investment → further weaken activity and trade interlinkages).
  - Commodity market disruptions → higher inflation → monetary tightening → lower asset prices and higher borrowing costs → financial stability risks.
- Additional channels affecting macro-financial stability noted in the chapter:
  - Increased cybersecurity, compliance, legal, reputational risks.
  - Fragmentation of commodity markets and impediments to international cooperation on climate change, potentially increasing risk of a disorderly climate transition.
  - Risks to debt restructuring/cooperation that could harm creditors and borrowers.

### Empirical and measurement notes on geopolitical metrics
- Geopolitical distance is measured using divergence in countries’ voting behavior in the UN General Assembly (Häge 2011 measure; based on the “S” measure in Signorino and Ritter 1999), where more dissimilar voting patterns imply greater geopolitical distance.
- Sensitivity checks use alternative UN voting measures (Häge 2011; Bailey, Strezhnev, and Voeten 2017) and proxies such as bilateral financial sanctions and arms trade.
- Correlation between geopolitical distance measures from Häge (2011) and Bailey, Strezhnev, and Voeten (2017) ranges from 0.6 to 0.9.
- Likelihood of imposing financial sanctions is significantly higher for country pairs that are more geopolitically distant.

### Implications of financial fragmentation and heterogeneity across countries
- Financial fragmentation effects:
  - Limits diversification of international assets and liabilities, increasing vulnerability to shocks.
  - Can increase long-term volatility of capital flows and domestic asset returns, making systems more susceptible to crises.
- Country-specific asymmetries:
  - Impact depends on financial interconnectedness, level of financial development, and size of external buffers.
  - Countries whose currencies are widely held as international reserves may face shifts in foreign official investor preferences toward reserve assets of geopolitically aligned countries.
  - In some cases, reallocation toward geopolitically aligned financing could improve continuity of external finance if it replaces less predictable financing, but absorptive capacity and policy frameworks determine benefits.
- Cross-border spillovers:
  - Effects can spill over beyond directly involved countries (losses at financial institutions, withdrawal of credit lines, asset price declines, high inflation, slowdown in activity).
  - Spillovers are larger when tensions involve major, globally integrated economies.
  - Neutral countries might attract reallocated capital, conditional on absorptive capacity and policies.

### Historical and recent developments in global financial integration (select findings)
- Broad trends:
  - Total external financial assets and liabilities expanded rapidly in the 1990s and through most of the 2000s.
  - Momentum slowed after the global financial crisis; capital flows relative to output have been well below precrisis peaks in advanced economies and in emerging market and developing economies.
- Drivers of reduced cross-border capital movements:
  - Decline in banking flows due to retrenchment of global banks from foreign jurisdictions.
  - Increasing use of official restrictions on capital flows (capital account restrictions on inflows and outflows have increased notably since the global financial crisis).
  - Correspondent banking relationship reductions, particularly in developing economies, and regulatory changes affecting banks also contributed.
- Capital account restrictiveness:
  - Capital account restrictions have increased since the global financial crisis and are now almost as prevalent as the levels observed in the early 1990s in both advanced economies and emerging market and developing economies.
  - Note: measures capture presence of restrictions but not intensity; earlier-period restrictions may have been more severe.
- Shifts in global financial roles:
  - The United States continues to dominate global debt and portfolio equity investment; its share in foreign direct investment has declined.
  - China and several international financial centers (such as Ireland and Luxembourg) have grown in importance, with notable increases in their holdings of external assets.
- Bilateral interlinkages and concentration:
  - Bilateral financial interlinkages appear to have weakened in recent years; cross-border investment has become more concentrated in fewer partner countries.
  - Advanced economies and emerging market and developing economies tend to have closer financial relationships with advanced economies.
  - In recent years, cross-border financial exposures among advanced economies have increased, while overall international financial exposures are becoming increasingly concentrated in major advanced and emerging market economies.
- Geopolitics and capital allocation:
  - Geopolitical affinities (UN voting similarity) appear to matter for cross-border capital allocation; recent data suggest weakening financial ties between the United States/Europe and Russia, and mixed trends for China with the United States and other major advanced economies.

### Key statistics and exact figures cited in the chapter
- Correlation between geopolitical distance measures from Häge (2011) and Bailey, Strezhnev, and Voeten (2017): ranges from 0.6 to 0.9.
- Time and scale references for global financial integration figures:
  - Panel 1: Global External Financial Assets and Liabilities, 1990–2021 (Percent of GDP) — series shown for 1990–2021 with marked periods: 1990–99, 2000–04, 2005–09, 2010–14, 2015–19 (figure source: External Wealth of Nations database; Fernández and others 2016; IMF, Balance of Payments Statistics; and IMF staff calculations).
  - Panel 2: Cross-Border Liability Flows, 1990–2022 (Percent of GDP) — series shown for 1990–2022 with periods 1990–98, 1994–2002, 2006–10, 2014–18, 2022.
  - Panel 3: Capital Account Restrictiveness (Index) — index plotted with scale 0.0, 0.1, 0.2, 0.3, 0.4, 0.5 for World, Advanced economies, Emerging market and developing economies across indicated time periods.
- Literature and empirical references (selected): Coeurdacier, Kollmann, and Martin (2010); Okawa and van Wincoop (2012); Reinhart and Rogoff (2009); Ghosh, Ostry, and Qureshi (2017); Phan, Tran, and Iyke (2022); Ghasseminejad and Jahan-Parvar (2021); Jung, Lee, and Lee (2021); Salisu and others (2022); Gurvich and Prilepskiy (2015); Busse and Hefeker (2007); Cavallo and Frankel (2008); Lane and Milesi-Ferretti (2018); Rankin, James, and McLoughlin (2014); Avdjiev and others (2020); Rice, von Peter, and Boar (2020); Aiyar and others (2023); Chiţu and others (2022); Ferguson (2008); Rajan (2022); Gaspar and Pazarbasioglu (2022).

*Source: IMF staff; CHAPTER 3 GEOPOLITICS ANd FINANCIAL FRAGMENTATION: IMPLICATIONS FOR MACRO-FINANCIAL STABILITY (April 2023).*

### CHAPTER 3 GEOPOLITICS ANd FINANCIAL FRAGMENTATION: IMPLICATIONS FOR MACRO-FINANCIAL STABILITY

### CHAPTER 3 GEOPOLITICS ANd FINANCIAL FRAGMENTATION: IMPLICATIONS FOR MACRO-FINANCIAL STABILITY

### Geopolitical factors and cross-border capital allocation
- A rise in geopolitical tensions weakens financial relationships between countries through higher transaction costs, informational asymmetries, mistrust, and fear of expropriation.
- Empirical analysis uses the gravity model of bilateral cross-border financial relationships (Portes and Rey 2005) and measures geopolitical distance by divergence in UN General Assembly voting behavior.
- Source countries allocate significantly less capital to recipient countries with which they have less agreement on foreign policy issues.
- US fund flows to China appear to respond to escalating political tensions between the two countries, although the effect thus far does not seem to have been persistent.

### Quantitative effects on portfolio, banking, and aggregate flows
- A one-standard-deviation increase in geopolitical distance between a source and a recipient country is associated with:
  - about a 15 percent reduction in bilateral cross-border allocation of portfolio investment and bank claims.
  - investment funds’ cross-border portfolio allocations decline by more than 20 percent.
- If geopolitical distance between a recipient country and all partner countries with which it already has little agreement on foreign policy issues were to increase by one standard deviation:
  - the median (mean) gross portfolio investment outflow would be equivalent to 1.5 (2.8) percent of the recipient country’s GDP.
  - the decline in portfolio flows could amount to about 3 percent of world GDP.
  - the median (mean) decline in cross-border banking flows would be 0.3 (1) percent of recipient country GDP.
- Alternative geopolitical distance measures (for example, bilateral arms trade or imposition of financial sanctions) yield broadly similar results:
  - a decline of one standard deviation in bilateral arms trade is associated with a 4–5 percent decline in equity portfolio investments and banking claims to the recipient country.
- Financial sanctions as a form of geopolitical escalation can notably disrupt cross-border payment activity:
  - imposing financial sanctions could reduce remittance volume to the sanctioned country by about 17.1 percent within six quarters while increasing the cost of remittances (fees and foreign exchange margins) by 3 percentage points.
- Aggregate (weighted-average) effects on net capital flows:
  - an increase of one standard deviation in geopolitical distance with a country’s financial partners is associated, on average, with a decline in net capital flows of about 3 percent of GDP for emerging market economies and about 2 percent of GDP for advanced economies.
  - for emerging market economies, a large portion of the total effect on net capital flows corresponds to a decline in portfolio flows.

### Implications for banks, lending, and financial stability
- Geopolitical tensions can affect the banking sector through multiple channels:
  - financial channel: sudden reversal of cross-border credit and investments increases banks’ debt rollover risks and funding costs.
  - market channel: wider sovereign bond and credit spreads reduce the values of banks’ assets and increase funding costs.
  - real channel: disruptions to supply chains and commodity markets can reduce growth and raise inflation, exacerbating banks’ market and credit losses.
- Bank-level empirical results (panel regressions on more than 5,000 banks from 52 economies) show that an increase in geopolitical distance to foreign lenders is associated with:
  - significantly increased banks’ funding costs,
  - reduced profitability,
  - contracted lending to the real economy.
- Effects are larger for emerging market and developing economies, indicating greater vulnerability and limited absorptive capacity.
- Nonlinearity: overall effects—particularly on banks’ lending—tend to be larger when tensions in relation to foreign lenders are already elevated (interaction with high-geopolitical-distance dummy above the 75th percentile).
- Well-capitalized banks are less affected:
  - banks with capital ratios in the top 25th percentile experience smaller increases in borrowing costs, smaller declines in profits, and smaller reductions in lending than other banks.
  - implication: building bank capital buffers should be considered an effective way to mitigate the transmission of geopolitical shocks to the real economy.

### Financial fragmentation and macro-financial volatility
- Global financial fragmentation resulting from escalated geopolitical tensions can lead to loss of international risk diversification benefits and greater vulnerability to adverse shocks.
- Some countries could gain capital inflows from geopolitically closer partners, potentially emerging as beneficiaries of rising global geopolitical tensions; however, the macro-financial implications of such inflows depend on absorptive capacity, policy frameworks, and stability of the flows.
- Results are robust to controls for common global factors, macroeconomic and structural country characteristics, and bilateral factors such as geographical distance and cultural ties; regressors are lagged by one period in the analyses to mitigate endogeneity concerns.

*International Monetary Fund | April 2023 — CHAPTER 3 GEOPOLITICS ANd FINANCIAL FRAGMENTATION: IMPLICATIONS FOR MACRO-FINANCIAL STABILITY*

### 2. Portfolio Flows to GDP

### 2. Portfolio Flows to GDP

### Financial fragmentation and portfolio reallocation — key empirical findings
- The bars represent the percentage-point change in total net capital flows to GDP in response to a one-standard-deviation increase in geopolitical distance with a country’s financial partners. Solid bars indicate statistical significance at the 10 percent level or lower.
- In the face of an adverse foreign monetary policy shock—proxied by a 100-basis-point increase in the monetary policy rate of an economy’s largest financial partner—net capital flows to emerging market economies with more concentrated international financial positions decline notably; the effect is on average about 2 percent of GDP and persistent, lasting up to eight quarters.
- The effect of a foreign monetary policy shock of a similar magnitude on emerging market economies with less concentrated international financial exposures is neither economically nor statistically significant.
- Moving from full diversification (equal exposures to all countries) to extreme concentration (only one partner country) implies a 5.5 percentage-point increase in the volatility of net capital flows to GDP. The effect is more pronounced for emerging market economies than for advanced economies and is stronger for countries with smaller stocks of international reserves.
- Countries with more concentrated cross-border financial positions experience higher volatility of net capital flows to GDP; bars indicate statistical significance at the 10 percent level or lower.

### Banks’ performance after increased geopolitical distance with foreign lenders
- Outcome variables and identification:
  - (1) Total interest expenses-to-total interest-bearing liabilities (cost of funding, percentage points).
  - (2) (log) Operating profits-to-total assets (profitability, percent).
  - (3) (log) Real outstanding gross loans (gross loans in local currency terms divided by the domestic consumer price index) (lending, percent).
  - Effects are estimated for a one-standard-deviation increase in geopolitical distance; regressions include an interaction with a high-distance dummy (above the 75th percentile).
- Main effects:
  - After an increase in geopolitical distance with foreign lenders, especially in emerging market and developing economies, banks experience higher funding costs.
  - Banks experience lower profitability.
  - Banks contract lending to the domestic economy.
  - Solid bars indicate statistical significance at the 10 percent level or lower.
- Bank capitalization interaction (EMDEs only):
  - “High capital ratio” corresponds to banks with equity-to-total assets ratio above the 75th percentile of banks in a given country in a given year.
  - Banks with relatively lower capital ratios experience a greater increase in borrowing costs than more well-capitalized banks.
  - Banks with relatively lower capital ratios experience a larger decline in profitability.
  - Banks with relatively lower capital ratios experience a larger decline in lending.

### Remittances and cross-border payment disruptions
- Remittances context:
  - Remittances are an important source of external income for many economies—on average, amounting to about 2.5 percent of GDP, but in some cases more than 26 percent.
  - G20 countries have committed to reducing the global average remittance cost to 5 percent; the UN Sustainable Development Goals target 3 percent to be reached by 2030.
- Recent trends and sanction effects:
  - The average cost of sending remittances (weighted by the volume of remittances) to Eastern Europe and Central Asia surged by 27.4 percent between the end of 2021 and the second quarter of 2022.
  - A formal analysis of financial sanctions on remittances in 18 countries from the first quarter of 1980 to the second quarter of 2022 finds:
    - Financial sanctions increase the cost of sending remittances (measured as a percentage of the remitted amount) to sanctioned countries by 3 percentage points.
    - The volume of remittances drops by 17.1 percent after six quarters of sanctions.

### Macro-financial amplification and welfare implications
- Reduced diversification of international financial positions is associated with greater volatility of capital flows and amplifies the propagation of external macro-financial shocks, especially to emerging market economies.
- The welfare loss from reduced risk diversification could be notable even in more advanced economies: a scenario analysis for the Group of Seven economies suggests that volatility of macro-financial variables such as output, consumption, corporate profits, and stock and bond prices could increase notably under fragmentation, implying a significant loss of diversification benefits.

### Policy conclusions and recommendations
- Strengthen Financial Oversight
  - Supervisors, regulators, and financial institutions should identify, quantify, manage, and mitigate risks from a potential rise in geopolitical tensions.
  - Geopolitical risks and their transmission mechanisms should be more formally embedded in stress-testing frameworks and scenario analysis (including through the Internal Capital Adequacy Assessment Process).
- Build Adequate Buffers and Safety Nets
  - Economies reliant on external financing should ensure an adequate level of international reserves as well as capital and liquidity buffers at financial institutions.
  - The transmission of geopolitical shocks should be considered in the quantification of credit, interest rate, market, liquidity, and operational risks; buffers should be calibrated to protect against extreme but plausible losses associated with tail risk.
  - Strengthen crisis preparedness and management frameworks, and maintain cooperative arrangements for effective management and containment of international financial crises, including resolution mechanisms for cross-border institutions.
  - Mutual assistance agreements—through regional safety nets, currency swaps, or fiscal mechanisms—could help smaller countries weather shocks; demand for global financial safety nets will increase.
  - The IMF could play a role through financing facilities, particularly the precautionary lending toolkit, and through policy advice and capacity development.
- Strengthen International Cooperation
  - International regulatory and standard-setting bodies should continue promoting convergence in financial regulations and standards to prevent increased financial fragmentation.
  - Deepen international cooperation to improve cross-border payments and develop frameworks to enhance interoperability of payment systems to mitigate disruptions.
  - Policymakers should weigh national security–driven financial restrictions against potential global macro-financial stability risks, including financial fragmentation, higher inflation, lower global growth, and financial contagion, and pursue diplomacy to prevent escalation of geopolitical tensions.

*Source: IMF, Chapter 3 — GEOPOLITICS ANd FINANCIAL FRAGMENTATION: IMPLICATIONS FOR MACRO-FINANCIAL STABILITY (figures, notes, and empirical results as presented in the source content).*

### 1. Change in Cross-Border

### 1. Change in Cross-Border

### Remittances: effect of financial sanctions on costs and volumes
- Finding: Financial sanctions increase remittance costs.
  - Chart scale presented: –30, –20, –10, 0, 10, 20, 30 (Percent, annual average).
  - Panel 1 note: Growth rate of regional average remittance costs (when sending $200) weighted by the remittance volume (World Bank 2022). Regional grouping includes six regions: East Asia and Pacific, Europe and Central Asia, Latin America and the Caribbean, Middle East and North Africa, South Asia, and sub-Saharan Africa. Europe and Central Asia grouping only includes countries in Eastern Europe and Central Asia.
  - Right bar in panel 1 denotes the change from the fourth quarter of 2021 to the second quarter of 2022.
  - Data do not include corridors originating in Russia in 2022.
- Finding: Sanctions reduce remittance volumes to sanctioned countries.
  - Panel 3 axis scale presented: –50, –40, –30, –20, –10, 0, 10 (Percent).
  - Panels 2 and 3 show cumulative abnormal changes in remittance cost ratios and remittance volume after sanctions; horizontal axis label t+1+2+3+4+5+6 indicates periods after sanctions.
  - The remittance cost is measured as a ratio of total costs to the remitted $200.
  - Analyses do not consider the effect of the sanction on Russia in 2022 because of limited data availability.
- Sources for empirical panels: Global Sanctions Database; World Bank, Remittance Prices Worldwide; IMF, Balance of Payment Statistics; and IMF staff calculations.
- Reference: See Online Annex 3.5 for further details of the empirical analysis.

### Geopolitical tensions, financial fragmentation, and macro‑financial volatility (Box 3.2 summary)
- Context: Financial fragmentation driven by escalation of geopolitical tensions can limit international risk diversification and increase volatility of macro‑financial variables (output, consumption, corporate profits, asset prices).
- Model: Two-country open‑economy model with trade in stocks and bonds (Coeurdacier, Kollmann, and Martin 2010) calibrated to G7 economies and a rest‑of‑world sample of 53 countries; designed to explain “equity home bias” and generate macro‑financial dynamics after total factor productivity and investment‑specific technology shocks.
- Fragmentation scenarios simulated for each G7 economy:
  - Full integration: G7 trade with rest of world.
  - Moderate fragmentation: unable to engage in financial transactions with countries whose geopolitical distance measure lies in the top 25th percentile of the sample distribution.
  - Extreme fragmentation: unable to engage with countries whose geopolitical distance measure lies in the top 50th percentile of the sample distribution.
  - Autarkic scenario: G7 economies financially cut off from all other economies.
- Quantified changes in median volatility (relative to full integration):
  - Output: increases by 1 and 3 percentage points under the “moderate” and “extreme” fragmentation scenarios, respectively.
  - (Real) Consumption, corporate profits, equity and bond prices: increases in the range of 2–8 percentage points under fragmentation scenarios.
  - Figure label: Full integration = 100 (panel 1 shows median volatility (standard deviation) under fragmentation scenarios).
- Loss of diversification benefits (ratio of changes in volatility versus autarky):
  - “Moderate” fragmentation implies about 20 percent of diversification benefits from financial integration would be lost.
  - “Extreme” fragmentation implies nearly 40–50 percent of the benefits would be lost.
  - Figure label: Loss of Diversification Benefit under Fragmentation (Percent relative to the loss under autarky).
- Caveats noted in the source:
  - Simulations focus only on loss of cross‑border investment diversification benefits and assume full substitutability of foreign goods production among available trading partners.
  - Alternative assumptions or broader geoeconomic fragmentation affecting trade, technology diffusion, and labor migration could impose additional costs.
  - Simulations do not account for potential benefits from fragmentation (for example, capital reallocation) or whether fragmentation reduces threats to national or global security.
  - Magnitudes are in line with studies using a production economy with capital but are smaller than those assuming an endowment economy because capital in a production economy can smooth shocks in autarky.

### Model details and references
- Model purpose: explain equity home bias and capture diversification benefits from foreign equity holdings given imperfectly correlated shocks across economies; home bias arises because wage income and dividends from domestic equity are imperfectly correlated, providing domestic risk diversification opportunities.
- Further details: Online Annex 3.7 presents structure and parameterization of the model.
- Comparative literature notes: Magnitudes compared with Coeurdacier, Rey, and Winant 2020 and Van Wincoop 1999 are discussed in the source.

*Source: IMF staff calculations and text from Box 3.1 and Box 3.2 (CHAPTER 3), Global Financial Stability Report, April 2023.*

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_Source: https://www.imf.org/-/media/files/publications/gfsr/2023/april/english/ch3.pdf_