Geoeconomic fragmentation looms over euro area financial stability

Financial exposures to geopolitical risks have increased over time

Geopolitical tensions have economic costs, causing, for example, both international trade and cross-border capital flows to suffer. This is geoeconomic fragmentation. A recent ESM discussion paper examines the implications for the euro area’s external financing.

We find that the past two decades have seen an increase in the euro area’s financial exposure to the risk of geoeconomic fragmentation (see Figure 1). The euro area has deepened its financial ties with countries whose foreign policies are now increasingly at odds with Europe’s own, such as China and Russia. Summed across all financial instruments, these positions towards geopolitically distant countries ^[1] more than doubled since 2008, peaking at 60% of euro area GDP in 2020. Then, by mid-2023 they had fallen below 50% of GDP, indicating ongoing fragmentation.

Pockets of vulnerabilities

Foreign direct investment (FDI) and portfolio investment exposures to geopolitically distant countries stand out in aggregate (see Figure 2) but vary across euro area member states. ^[2] Large euro area countries tend to have larger FDI investments in other countries that may be at risk, while smaller economies tend to be mainly recipients of inward FDI. Euro area investors have cut back on their investments in geopolitically distant countries recently, but FDI investments from distant countries into the euro area have been little affected.

Portfolio investments from geopolitically distant countries to euro area securities reach 8.3% of GDP, including a significant portion of sovereign debt held as reserves by foreign central banks. Our estimates suggest that roughly one third of euro area sovereign debt held by non-euro area investors is in the hands of non-politically aligned countries as official reserves, although this figure comes with high uncertainty due to data limitations. ^[3]

Portfolio investments sensitive to geopolitics

Rising geopolitical tensions strain the euro area’s financial links to other countries. Empirical evidence confirms that investor countries allocate smaller investments to partners with differing foreign policy views. This sensitivity is particularly pronounced for portfolio investments to and from euro area member states (see Figure 3). If geopolitical distance between countries increases, these investments decline. ^[4] Geopolitical factors can also play a role in the currency composition of foreign exchange reserves. ^[5]

Adverse geopolitical events can also impact portfolio flows between the euro area and the rest of the world more broadly. Foreign investors’ behaviour towards the euro area can shift depending on the prevailing level of geopolitical risk.

The euro area is usually seen as safe haven, attracting net portfolio inflows. Typically, when a geopolitical shock hits, euro area investors withdraw from foreign equities, while foreigners increase their purchases of euro area equities, resulting in net equity inflows. Additionally, the search for safety prompts inflows into euro area debt securities, as long as geopolitical risks are generally contained.

However, portfolio debt inflows become fickle in a geopolitically risky environment. Our analysis suggests that when geopolitical risks are more elevated, shocks can trigger portfolio outflows from the euro area (see Figure 4). This puts further constraints on the euro area’s external financing.

Diversification and risk-sharing can help

As geopolitical risks increase, financial shocks to the euro area become more frequent and intense. The euro area’s response should not, however, be isolation, as this would reinforce fragmentation. The euro area stands to lose if globalisation reverses, and global financial markets become fragmented. Financing would become more scarce and costly.

Instead of decoupling, a diversification of the euro area’s global financial linkages can help mitigate financial shocks. Domestically, risk-sharing through the help of the ESM, banking union, and capital markets union would support the euro area’s resilience in the face of today and tomorrow’s increasing global volatility.

Acknowledgements

The authors would like to thank Pilar Castrillo, Graciela Schiliuk, and Rolf Strauch for their valuable comments and contributions to this blog post, as well as AMRO colleagues for valuable discussions, and Raquel Calero for the editorial review.

This blog is based on Chapter 3 of the ESM joint discussion paper with AMRO staff, “Geoeconomic fragmentation: Implications for the euro area and ASEAN+3 regions”.