Geopolitical And Economic Uncertainty: Deep Impact?

Geopolitical risks and economic outlook.Geopolitical risks and economic outlook

Caixabank | The relationship between geopolitics and economic variables is a recurrent theme in the media. An not just in the media: economists are increasingly more aware of the importance of analysing geopolitical risks to complete an accurate exercise on the economic outlook. And yet, despite the fact that geopolitics is fasionable, there is hardly any analysis which quantifies this relationship. In this article, we will break the ban with an initial examination of the issue.

In order to measure global geopolitical uncertainty in a precise way, we are creating an index which takes into account both the global political uncertainty as well as the evolution of the conflicts, also on a global level. To start the analysis, it’s useful to study the degree of co-relation between the index of geopolitical uncertainty and different indicators of activity. A first step in this sense consists in analysing the relationship of the afore-mentioned index with global PMI. As we can see in the first graphic, the relationship between the two is clearly negative: the higher the index of geopolitical uncertainty, the lower the business confidence index. Another example of the fact the relationship between the two seems very narrow is that an increase in the uncertainty index of a magnitude equivalent to that in November 2016, after Donald Trump’s unexpected victory, is usually accompanied by a reduction of 4 points in the PMI. So that the reader can have an idea of the magnitude, around the average value of the PMI index, in a range of 5 points, we find 50% of the observations.

Another way of analysing the relationship between geopolitical uncertainty and economic activity is to directly observe the correlation between geopolitical uncertainty and global GDP growth. In this case, an increase in the uncertainty of the magnitude equivalent to that in Q4 2016 is usually associated with a decline in global GDP growth of 0.3 percentage points in that same quarter.

Finally, another way of evaluating the intensity of the relationship between the index of geopolitical risk and the indicators of economic activity is compare it with what be seen in similar indices, but in other areas. In this sense, a good reference is the index of financial volatility, the VIX, given that in this case it is well known that the increases in this index usually have important repercussions on economic activity. Well a rise of the same magnitude in both indices is usually associated with similar declines in global GDP growth. Specifically, if we apply to the VIX index a shock of the magnitude equivalent to that which happened with the geopolitical risk index in Q4 2016, the drop in global GDP growth would have been approximately 0.4 percentage points.

The results presented in the previous paragraph are useful to obtain a first approximation of the relationship between geopolitics and the economy, but they only measure correlations. In other words, they show how the economic and geopolitical variables work together, but don’t distinguish the cause of the effect (does geopolitical uncertainty rise for strictly geopolitical reasons or are there other variables which are the origin of these changes?). In the interest of a more sophisticated analysis, we are using a statistics technique which allows us to quantify the impact of a shock of uncertainty with an external origin, caused by geopolitical motives, on the economy over time. As we can see in the second graphic, it is estimated that a shock of uncertainty with a magnitude like that in Q4 2016 generates a reduction of almost 1 percentage points on world growth six months to a year after it happens.

One question which is relevant to understanding the channel through which global geopolitical uncertainty operates is whether its impact is similar in the developed countries and the emerging ones. As we can see in the third graphic, the emerging countries as a whole tolerate geopolitical uncertainty much worse than the developed countries. Specifically, at the critical moment of the geopolitical shock (three quarters after it happened), the fall in GDP growth in the emerging markets 1,4 times greater than in the developed ones. Whatsmore, the effect on the emerging countries is much more persistent over time than in the developed ones. The asymetry observed between the advanced block and the emerging one could be down to the fact that the advanced countries have a much more mature and consolidated institutional system which provides them with a bigger buffer to deal with uncertainty of a geopolitical kind. On the other hand, many emerging countries are still immersed in a process of consolidation in terms of their institutional environment. This makes them more fragile and, as a result, more sensitive to geopolitical fluctuations. As a result, the emerging countries should have more interest in avoiding tensions which generate geopolitical uncertainty.

Finally, we analyse the importance of geopolitical factors to explain world growth over time. For that, we have studied the contribution from global geopolitcal factors, microfinancing conditions and financial volatility (VIX) to explain the variation in GDP growth at a global level. We divide the example into three periods: from 2000 to 2007 (the previous expansionary cycle), from 2008 to 2012 (economic crisis) and from 2012 to 2017 (recovery).

There is no doubt about the results. The geopolitical factors have lost importance with respect to the expansionary cycle prior to the economic crisis of 2008 and 2009, but they remain important: between 2000 and 2007, the geopolitical factors accounted for 49% of the variance in global growth; between 2008 and 2012, the contribution was only 13% (the macrofinacing conditions explained 62% and reflected the impact of the financial crisis) and between 2013 and 2017, the contribution was a significant 30% (the volatility and macrofinancing conditions explained 41% and 29% respectively).

The major explanatory power of geopolitical factors between 2000 and 2007 could be down to the fact there was a low level of geopolitical tensions (with the exception of the period between 2001 and 2003, coinciding with the 9-11 attacks and the invasion of Afghanistan and Irak), in such a way that the geopolitics was a key support factor for growth. On the other hand, after the crisis, macrofinancing factors have become more important: the QE monetary programmes have contributed to a very important decline in volatility and accomodative financial conditions have driven economic growth. That said, it seems the importance of geopolitical factors is increasing, a trend which could become stronger as financial conditions stop being so lax and if the rise in populism continues.