Quantifying the macroeconomic impact of geopolitical risk

Julian
Reynolds

Policymakers
and
market
participants
consistently
cite
geopolitical
developments
as
a
key
risk
to
the
global
economy
and
financial
system.
But
how
can
one
quantify
the
potential
macroeconomic
effects
of
these
developments?
Applying
local
projections
to
a
popular
metric
of
geopolitical
risk,
I
show
that
geopolitical
risk
weighs
on
GDP
in
the
central
case
and
increases
the
severity
of
adverse
outcomes.
This
impact
appears
much
larger
in
emerging
market
economies
(EMEs)
than
advanced
economies
(AEs).
Geopolitical
risk
also
pushes
up
inflation
in
both
central
case
and
adverse
outcomes,
implying
that
macroeconomic
policymakers
have
to

trade-off
stabilising
output
versus
inflation.
Finally,
I
show
that
geopolitical
risk
may
transmit
to
output
and
inflation
via
trade
and
uncertainty
channels.

How
has
the
global
geopolitical
outlook
evolved?

Risks
from
geopolitical
tensions
have
become
of
increasing
concern
to

policymakers
and

market
participants
this
decade.

A
popular
metric
to
monitor
these
risks
is
the

Geopolitical
Risk
(GPR)
Index
constructed
by

Caldara
and
Iacoviello
(2022).
The
authors
construct
their
index
using
automated
text-search
results
from
newspaper
articles.
Namely,
they
search
for
words
relevant
to
their
definition
of
geopolitical
risk,
such
as
‘crisis’,
‘terrorism’
or
‘war’.
They
also
construct
GPR
indices
at
a
disaggregated
country-specific
level,
based
on
joint
occurrences
of
key
words
and
specific
countries.

Chart
1
plots
the
evolution
of
the
geopolitical
risks
over
time.
Most
notably,
the
Global
GPR
Index
(black
line)
spikes
following
the
September
11
attacks.
More
recently,
this
index
shows
a
sharp
increase
following
Russia’s
invasion
of
Ukraine
in
February
2022.

Country-specific
indices
typically
co-move
significantly
with
the
Global
index
but
may
deviate
when
country-specific
risks
arise.
For
instance,
the
UK-specific
(aqua
line)
and
France-specific
indices
(orange
line)
show
more
pronounced
spikes
following
terrorist
attacks
in
London
and
Paris
respectively,
while
the
Germany-specific
index
(purple
line)
rises
particularly
strongly
following
the
invasion
of
Ukraine.

Chart
1:
Global
and
country-specific
Geopolitical
Risk
Indices

The
GPR
index
is
similar
to
the
Economic
Policy
Uncertainty
(EPU)
index,
produced
by Baker,
Bloom
and
Davis.
The
EPU
index
is
also
constructed
based
on
a
text
search
from
newspaper
articles,
and
available
at
both
a
global
and
country-specific
level.
But
it
measures
more
generic
uncertainty
related
to
economic
policymaking,
besides
uncertainty
stemming
from
geopolitical
developments.

How
to
quantify
the
macroeconomic
impact
of
these
developments?

In
light
of
increasing
concerns
about
geopolitical
tension,
a
growing
body
of
literature
aims
to
quantify
the
macro-financial
impact
of
these
developments.
For
instance,

Aiyar
et
al
(2023)
examine
multiple
transmission
channels
of
‘geoeconomic
fragmentation’
–
a
policy-driven
reversal
of
global
economic
integration
–
including
trade,
capital
flows
and
technology
diffusion.
Also
Caldara
and
Iacoviello
(2022)
employ
a
range
of
empirical
techniques
to
examine
how
shocks
to
their
GPR
affect
macroeconomic
variables.

These
studies
unambiguously
show
that
geopolitical
tension
has
adverse
effects
on
macroeconomic
activity
and
contributes
to
greater
downside
risks.
But
empirical
estimates
tend
to
differ
significantly,
depending
on
the
nature
and
severity
of
scenarios
through
which
geopolitical
tensions
may
play
out.

My
approach
focusses
on
the
impact
of
geopolitical
risks
on
a
range
of
macroeconomic
variables.
Namely,
I
use
local
projections
(Jordà
(2005)),
an
econometric
approach
which
examines
how
a
given
variable
responds
in
the
future
to
changes
in
geopolitical
risk
today.
I
employ
a
panel
dataset
of
AEs
and
EMEs
(listed
in

Table
A),
with
quarterly
data
from
1985
onwards.

Table
A:
List
of
economies

Notes:
Countries
divided
into
Advanced
and
Emerging
Market
Economies
as
per
IMF
classification.
Country-level
EPU
indices
available
for
starred
economies.

Following
Caldara
and
Iacoviello
(2022),
I
regress
a
given
variable
on
the
country-level
GPR
index,
controlling
for:
country-level
fixed
effects;
the
global
GPR
index;
the
first
lag
of
my
variable
of
interest;
and
the
first
lags
of
(four-quarter)
GDP
growth,
consumer
price
inflation,
oil
price
inflation,
and
changes
in
central
bank
policy
rates.

I
use
ordinary
least
squares
estimation
to
estimate
the
mean
response
over
time
of
a
given
macroeconomic
variable
to
geopolitical
risk.
But
to
assess
the
impact
of
geopolitical
risk
at
the
tail
of
the
distribution,
I
follow

Lloyd
et
al
(2021)
and

Garofalo
et
al
(2023)
by
using
local-projection
quantile
regression.
This
latter
approach
uses
an

outlook-at-risk
framework
to
illustrate
how
severe
the
impact
of
geopolitical
risk
could
be
under
extreme
circumstances.

How
does
geopolitical
risk
affect
GDP
growth
and
inflation?

Chart
2
show
the
impact
of
geopolitical
risk
on
average
annual
GDP
growth
across
my
panel
of
economies.
In
the
mean
results
(aqua
line),
a
one
standard
deviation
increase
in
geopolitical
risks
is
expected
to
reduce
GDP
growth
by
0.2
percentage
points
(pp)
at
peak.
But
at
the
5th
percentile
–
a
one-in-twenty
adverse
outcome
–
GDP
growth
falls
by
almost
0.5pp.
In
other
words,
this
means
that
geopolitical
risk
both
weighs
on
GDP
growth
but
also
increases
the
severity
of
tail-risk
outcomes,
adding
to
the
global
risk
environment.

The
magnitude
of
these
effects
is
somewhat
smaller
than
Caldara
and
Iacoviello
(2022),
though
they
use
a
longer
time
sample
(1900
onwards),
which
includes
both
World
Wars.

Chart
2:
Dynamic
impact
of
geopolitical
risk
on
GDP
growth

Notes:
Shaded
areas
denote
68%
confidence
interval
around
Mean
and
5^th
Percentile
estimates.

The
impact
of
geopolitical
risks
on
GDP
growth
is
heterogeneous
across
AEs
and
EMEs.

Chart
3
plots
the
impact
of
geopolitical
risk
at
the
one-year
horizon
for
both
groups
of
economies,
at
the
mean
and
5th
percentile.
For
AEs,
the
mean
impact
of
geopolitical
risk
on
GDP
growth
appears
to
be
negligible,
though
the
5th
percentile
impact
is
more
noticeable.
For
EMEs,
however,
both
the
mean
and
5th
percentile
impact
of
geopolitical
risk
are
material.
This
result
is
consistent
with
Aiyar
et
al
(2023),
who
show
that
EMEs
are
also
more
sensitive
to
geoeconomic
fragmentation
in
the
medium-term.

Chart
3:
Impacts
of
geopolitical
risk
on
GDP
growth
at
one-year
horizon,
by
country
group

Notes:
Shaded
areas
denote
68%
confidence
interval
around
Mean
and
5th
Percentile
estimates.

I
also
find
that
geopolitical
risk
tends
to
raise
consumer
price
inflation,
consistent
with

Caldara
et
al
(2024)
and

Pinchetti
and
Smith
(2024).
This
could
pose
a
challenging
trade-off
for
a
macroeconomic
policymaker,
between
stabilising
output
versus
inflation.

Chart
4
shows
that
at
the
mean,
average
annual
inflation
rises
by
0.5pp
at
peak,
following
a
geopolitical
risk
shock.
But
at
the
95th
percentile
(one-in-twenty
high
inflation
outcome),
inflation
rises
by
1.4pp.
As
with
GDP,
the
inflationary
impact
of
geopolitical
risk
shocks
appears
to
be
larger
for
EMEs,
though
the
mean
impact
on
AE
inflation
is
also
statistically
significant
(Chart
5).

Chart
4:
Dynamic
impact
of
geopolitical
risk
on
consumer
price
inflation

Notes:
Shaded
areas
denote
68%
confidence
interval
around
Mean
and
95th
percentile
estimates.

Chart
5:
Impact
of
geopolitical
risk
on
consumer
price
inflation
at
one-year
horizon,
by
country
group

Notes:
Shaded
areas
denote
68%
confidence
interval
around
Mean
and
95th
Percentile
estimates.

What
are
the
potential
transmission
channels?

One
key
channel
through
which
geopolitical
risk
could
transmit
to
GDP
and
inflation
may
be
disruption
to
global
commodity
markets,
particularly
energy.
Pinchetti
and
Smith
(2024)
highlight
energy
supply
as
a
key
transmission
channel
of
geopolitical
risk,
which
pushes
up
on
inflation.
Energy
price
shocks
could
also
have
significant
effects
on
GDP
and
inflation
in
adverse
scenarios
(Garofalo
et
al
(2023)).

The
inflationary
impulse
following
Russia’s
invasion
of
Ukraine
marks
an
extreme
instance
of
commodity
market
disruption
(Martin
and
Reynolds
(2023)).
Sensitivity
analysis
suggests
that
even
excluding
this
period,
geopolitical
risk
still
has
trade-off
inducing
implications
for
inflation
and
GDP.

I
also
find
that
geopolitical
risk
leads
to
significant
disruption
in
world
trade,
a
channel
also
highlighted
by
Aiyar
et
al
(2023).

Chart
6
plots
the
estimated
impacts
on
trade
volumes
growth
(measured
by
imports),
while

Chart
7
plots
the
impact
on
trade
price
inflation
(measured
by
export
deflators).
These
results
imply
that
both
trade
volumes
and
prices
are
highly
sensitive
to
global
geopolitical
risk.
The
peak
response
of
trade
volumes
growth
to
geopolitical
risk
is
around
three
times
greater
than
GDP,
at
the
mean
and
5th
percentile.
And
the
peak
response
of
export
price
inflation
–
representing
the
basket
of
tradeable
goods
and
services
–
is
significantly
greater
than
that
of
consumer
prices,
at
the
mean
and
95th
percentile.

This
implies
that
countries
are
likely
to
be
exposed
to
global
geopolitical
risk
via
the
effect
on
trading
partners:
falling
import
volumes
for
Country
A
means
that
Country
B’s
exports
fall,
weighing
on
GDP;
higher
export
prices
for
County
A
means
that
Country
B
imports
higher
inflation
from
Country
A.

Chart
6:
Dynamic
impact
of
geopolitical
risk
on
trade
volumes
growth

Notes:
Shaded
areas
denote
68%
confidence
interval
around
Mean
and
5th
Percentile
estimates.

Chart
7:
Dynamic
impact
of
geopolitical
risk
on
trade
price
inflation

Notes:
Shaded
areas
denote
68%
confidence
interval
around
Mean
and
95th
Percentile
estimates.

Finally,
I
find
that
greater
geopolitical
risk
is
associated
with
somewhat
greater
economic
uncertainty.

Chart
8
shows
the
response
of
country-specific
EPU
indices
(compiled
by
Baker,
Bloom
and
Davis)
to
an
increase
in
geopolitical
risk.
This
implies
a
mean
cumulative
increase
in
uncertainty
of
around
0.1
standard
deviations;
the
peak
impact
at
the
95th
percentile
is
twice
as
great.

This
impact,
while
statistically
significant,
appears
relatively
small
in
an
absolute
sense.
For
context,
the
US-specific
EPU
index
rose
by
two
standard
deviations
between
2017
and
2019,
after
the
onset
of
the
US-China
trade
war.
Nonetheless,
it
is
plausible
that
uncertainty
may
be
a
key
transmission
channel
for
geopolitical
tensions
in
the
medium
term,
which
may
particularly
weigh
on
business
investment (Manuel
et
al
(2021)).

Chart
8:
Dynamic
impact
of
geopolitical
risk
on
economic
policy
uncertainty

Notes:
Shaded
areas
denote
68%
confidence
interval
around
Mean
and
95th
Percentile
estimates.

Conclusion

This
post
presents
empirical
evidence
which
quantifies
the
potential
macroeconomic
effects
of
geopolitical
developments.
Geopolitical
risk
weighs
on
GDP
growth,
in
both
the
central
case
and
tail-risk
scenarios,
and
is
also
likely
to
raise
inflation
via
a
number
of
channels.

Further
studies
may
look
to
refine
the
identification
of
geopolitical
risk
shocks,
to
purge
the
underlying
series
of
endogenous
relationships
with
macroeconomic
variables.
Further
analysis
may
also
be
helpful
to
substantiate
why
EMEs
appear
more
sensitive
to
geopolitical
risk
than
AEs,
particularly
transmission
via
financial
conditions
and
capital
flows.
Given
the
heightening
geopolitical
tensions
that
policymakers
have
highlighted,
further
research
into
the
macro-financial
implications
of
these
tensions
is
highly
important
at
this
juncture.

---

Julian
Reynolds
works
in
the
Bank’s
Stress
Testing
and
Resilience
Group.

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