Origins of Geopolitical Risk, Economic Impacts and Trade Dynamics

Bilateral geopolitical risk and asymmetric economic effects

The paper by Irma Alonso-Alvarez, Marina Diakonova, and Javier J. Pérez advances the measurement and understanding of geopolitical risk (GPR) by developing a novel decomposition approach. Their work builds upon the influential GPR index created by Caldara and Iacoviello (2022) while addressing its limitations.

The authors construct geopolitical risk indices for six countries (US, China, Russia, UK, Germany, and France) using major local newspapers in each country’s native language. This approach recognizes that geopolitical risk perception varies by country and captures local perspectives that might be missed in the original English-language GPR index. The paper’s key methodological innovation is the introduction of “bilateral GPR” – the concept that geopolitical risks a country faces can be traced back to specific countries or regions that are the sources of those risks.

Findings

Country-specific risk sources

1. United States:
   – Middle East has historically been the main source of risk (40% of discourse)
   – Russia’s importance has increased fivefold over two decades (now 15-30%)
   – China-related risk has grown but remains relatively modest (14% by 2020s)
2. China:
   – Western Bloc dominates China’s geopolitical discourse (38% in 2020s)
   – Neighboring countries (Taiwan, Japan, Koreas) feature prominently
   – Russia’s contribution tripled after the Ukraine invasion
3. Russia:
   – Highest “internal” component (57%) among all countries studied
   – Immediate neighbors (especially Ukraine) are now the primary concern
   – Western Bloc historically significant but declining in importance
4. European Countries (UK, Germany, France):
   – Share similar risk perception patterns
   – Middle East is the primary source (~27% across all three)
   – Western Bloc follows closely, suggesting a common European perspective

Differential macroeconomic impacts

1. Negative GDP effects:
   – General GPR shocks tend to depress GDP across all countries
   – For the US, a GPR shock from Russia has twice the negative impact compared to one from China
   – Russia is most affected by shocks originating from its neighbors (Ukraine, Belarus, etc.)
2. Surprising positive effects:
   – A Middle East GPR shock is associated with increased US GDP (+0.8%)
   – China’s GDP benefits from shocks originating from neighboring countries
   – Russia’s GDP increases following Western Bloc-originated shocks (+2.5%)
3. Channels for positive effects:
   – Commodity markets: Energy prices benefit net exporters (US, Russia)
   – Military spending: Defense budget increases stimulate economic activity
   – Safe haven effects: Capital flows to perceived stable economies during crises

Rethinking GPR: The sources of geopolitical risk
Authors: Irma Alonso-Alvarez, Marina Diakonova, Javier J. Pérez
From: Banco de España

Sanctions, trade diversion, and the cost of reputational risk

In this paper, Giancarlo Corsetti, Banu Demir, and Beata Javorcik investigate how geopolitical fragmentation reshapes international trade, focusing on Turkey’s export dynamics with Russia following Western sanctions imposed after Russia’s 2022 invasion of Ukraine. The study reveals how sanctions create both opportunities and risks for firms in non-sanctioning countries, with significant heterogeneity in responses based on ownership ties and adjustments across pricing, payment methods, and currency choices.

The authors combine granular trade data with a theoretical framework to analyze firm-level decisions under sanctions. The analysis draws on a unique dataset of monthly Turkish exports from January 2021 to December 2023, disaggregated by firm, product (8-digit HS code), destination country, invoicing currency, and payment method. This microdata is enriched with firm census information, including ownership structure, to identify Turkish affiliates of Western multinational corporations (MNCs). A difference-in-differences design compares Turkish exports to Russia with exports to other destinations before and after the invasion.

The authors synthesize insights from trade and finance literature to model firm behavior under sanctions. Key considerations include:

1. Market power: Reduced competition in Russia allows Turkish firms to raise prices and markups.
2. Reputational risks: Western MNC affiliates face constraints due to potential secondary sanctions or backlash.
3. Payment security: Higher risks of non-payment incentivize shifts to cash-in-advance terms.
4. Currency costs: Sanctions raise transaction costs for Western currencies, prompting shifts to local or alternative currencies.

Findings

• Trade diversion and market entry: Turkish exports to Russia surged by 33% relative to other destinations post-invasion, reflecting trade diversion as Western firms exited the Russian market. Over 8,000 new Turkish firms entered Russia, doubling the number of exits. Western MNC affiliates, however, were 17 percentage points more likely to exit and contributed only 5% of exports to Russia by 2023, down from 16% pre-invasion.
• Ownership-driven heterogeneity
  – Domestic firms: Expanded exports aggressively, capitalizing on reduced competition.
  – Western MNC affiliates: Exhibited 21.5 percentage points lower export growth to Russia than domestic firms, with US-owned affiliates showing the strongest restraint.
  – Non-Western MNCs: Behaved similarly to domestic firms, indicating reputational risks were specific to Western ties.
• Pricing and contract adjustments
  – Markups and prices: Turkish firms increased unit values by 3.4–4.1%, reflecting heightened market power.
  – Payment terms: Cash-in-advance transactions rose by 6.4 percentage points to mitigate non-payment risks.
  – Currency shifts: Invoicing in US dollars and euros declined by 5.3 and 3.2 percentage points, respectively, while the Turkish lira’s share rose by 4.6 percentage points.
• Quantifying reputational costs: Western MNC affiliates forewent an estimated $50 million annually in Russian export revenue. Using trade elasticity estimates, this equates to tariff equivalents of 25% (long-run) to 376% (short-run), underscoring the economic weight of reputational risks.

Trading around Geopolitics
Authors: Giancarlo Corsetti, Banu Demir, Beata Javorcik
From: European University Institute, Oxford University