VIETNAM NATIONAL UNIVERSITY UNIVERSITY OF ECONOMICS AND BUSINESS Faculty of Finance and Banking IMPACT OF GEOPOLITICAL RISK ON EXTERNAL DEBT SUPERVISOR : Dr. Nguyễn Tường Van STUDENT : Đỗ Quyên - 20050511 CLASS : QH-2020-E - TCNH - CLC3 Table of Contents ABBREVIATIONS.---c- SH HH HH HH HH1 3 LIST OF FIGURES. --- sàng tt HH HTHrHrkkrrrerrrkrrkerrre 4 LIST OF TABLES .--- (5s HH HH HH HH HH HH TH HH HH HH HH HH HH HH HH HH, 5 Ly(x8 .--- 5-55 5+ nhe 7 CHAPTER 2: LITTERATURE REVIEW.x* HH HH HH THẾ Hàn HH HH HẾ Hà TH HH TH TH HH TH Hà gi giưt 11 2. External de@bIf.---‹---s++cx+erttrttrnHH HH HH HH HH HH Hà HH HH HH1 grrgờt 12 2.
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cà tk HH KH HH kết LIST OF TABLES Table 3.--------ce+rkerrrrrtrirtrirtkirtrrirtrirrrirrirrriirrrrrrrrrrirrriree 25 Table 4. Pairwise Correlations ÏÏ_.-----ss-srxerrrksrtrrtrtrrirtrrrtrriirrrrrrrrrrrierrrrirrrrrrrkerrrerie 31 Table 4. Variance inflation factOr .-- xe HH HH ceatessaseessueessaeeease 37 Table 4. Two-way Fixed effects regression reSuÏtS_.--c-ccxsrseerirrrirerirrrrrrrrirrrree 37 ABSTRACT This dissertation investigates the intricate relationship between geopolitical risk and two crucial aspects of external debt - external debt levels and debt service payments.
Focusing on 17 emerging countries over the period from 1985 to 2021, this research employs a Two-way fixed effects model with six key macroeconomic variables (GDP growth, Broad money, Domestic investment, GDP per capita, Inflation, and Trade openness) as control factors. The study's primary objective is to provide empirical evidence and valuable insights into how geopolitical risk influences a nation's financial health and its consequent impact on external debt dynamics. This investigation discerns a positive correlation between geopolitical risk and external debt levels, signifying that nations exposed to higher geopolitical risk tend to accumulate more external debt. This phenomenon is attributed to the economic and political instability often associated with these nations, which compels them to resort to external borrowing to stabilize their economies.
Furthermore, the study uncovers that geopolitical risk also leads to increased external debt service payments, driven by higher risk premiums, elevated interest rates, and currency depreciation. Additionally, this research highlights the complex interplay between political instability resulting from geopolitical events and the surge in external debt. Geopolitical crises often erode investor confidence, trigger capital flight, and necessitate external borrowing for economic stabilization. These findings underscore the importance of considering various economic factors when assessing a country's external debt dynamics and highlight the need for proactive strategies to manage geopolitical risks in the financial system.
This study contributes significantly to the understanding of the risks associated with national debt, offering policymakers and financial institutions valuable insights for developing strategies to mitigate the adverse effects of geopolitical risks on financial stability and economic development. CHAPTER 1: INTRODUCTION Geopolitical risk refers to the potential impact of political, economic, and social factors on the stability and security of a country or region (Jakir Hossain, 2021). It tends to rise when there are significant shifts in the geographic and political factors that underpin country relations. Over the past 30 years, the importance of geopolitical risk has increased significantly due to factors such as wars, terrorist attacks, conflicts, and rising tensions that disrupt the stable and peaceful nature of international relations (Caldara and Iacoviello, 2022).
Since the September 11 attacks, there have been numerous geopolitical risk events, including wars in Afghanistan, Iraq, and Syria, as well as conflicts such as the Russia-Georgia war and the Russia-Ukraine conflict. These events have contributed to a more than two-fold increase in global geopolitical risk (GPR) (Fig. Moreover, the COVID-19 pandemic has introduced high levels of uncertainty, further shaping the international landscape.00 On Wrnonr OrMNORATrTAMANNHR DOr MY 6 œ@ œ@ œ G @G@ œ@ @ © © © © © + = rrr AN ® .Gœ Gœ O0 ÖØ@ Ø0 ÖØ Ø0 SÔO©C©C©CC©CCcCcCcCcECSC — ®~ x TT TT x TĐ©' Q6 €6. 6 6 @@ Á@Ạ = <=S = =====YÝỀ€Ề Sẽ S9 S*S SS€ = mm mm rhrrrrrrrrr rẽ rẽrẽrcr = =S = =============k=k==== No rrr yr yr rrr PrP PP Se an Figure 1.
Global Geopolitical Risk The attention drawn to geopolitical risk events has shed light on its critical role in shaping the global economic and financial landscape. As tensions continue to intensify among major powers, worries are growing regarding prospects for geoeconomic fragmentation through reversals of economic and financial integration becoming increasingly determined by strategic political considerations rather than purely economic factors (Aiyar et al. This fragmentation could have detrimental effects on the world economy, the rise of “friendshoring” is an example. “Friendshoring” - foreign direct investment flowing more between countries that are political allies than those that are geographically close - was likely to increase the risk of economic downturns and could cut long term global output by 2 percent (World Economic Outlook, April 2023).
Moreover, wars and threats can trigger economic sanctions that restrict the access of the warring parties to capital markets, foreign assets, and financial services (Yu and Wang, 2023) or even induce capital outflow (OECD, 2022). As a result, geopolitical event play a crucial role in the allocation of cross-border capital (Lu et al, 2022), leading to an increase in restrictions on cross-border capital flows in both equity and debt markets. Indeed, geopolitical factors have long been recognized as influential drivers of equity markets, impacting both firm-level and national-level dynamics. Numerous studies have documented the significance of geopolitical risk in shaping equity market behavior, highlighting its effects on volatility, uncertainty, investor confidence, domestic investments, specific sectors, regions, and even currency markets.
Geopolitical risk can impact equity markets by increasing volatility and uncertainty (Dakhlaoui and Aloui, 2016, Hoque and Zaidi, 2020), while these negative impacts can erode investor confidence and reduce domestic investments (Le and Tran, 2021). Additionally, specific sectors and regions may experience indirect effects, and currency markets can be influenced, further affecting equity prices. While the impact of geopolitical risk on various aspects of equity markets has garnered significant attention, influence of geopolitical risk on international debt market remains ambiguous, especially at country level. According to the annual debt report of IMF in 2022, the world witnessed record levels of public debt borrowed from foreign sources, affecting both advanced and low- and middle-income economies.
Notably, the poorest and most vulnerable nations faced significant fiscal and debt vulnerabilities, with 60 percent of countries at a high risk of or already in debt distress, making them eligible for debt service suspension. Therefore, geopolitical factors play a substantial role in shaping the debt market. Escalated geopolitical tensions present a risk to both financial stability and political stability. These tensions can have repercussions through various channels, including financial and political avenues.
The intensification of geopolitical tensions has the potential to tighten global financial access conditions, worsen inflationary pressures, impede economic growth, and increase the strain on public finances. Consequently, the debt dynamics of low- and middle-income countries may be negatively impacted by these developments. In fact, many countries which are war-affected face rising debt arrears and deteriorating relations with creditors (Alvarez-Plata and Brủck, 2008). For instance, the invasion of Ukraine by Russia and subsequent sanctions imposed by the United States and the European Union have significantly affected cross-border banking and portfolio debt flows to Russia and its allied countries.
This geopolitical event led to a sharp reversal of capital allocations, with cross- border banking and portfolio debt flows decreasing by approximately 20% and 60%, respectively, compared to pre-conflict levels (World Economic Outlook, October 2023). External debt, which encompasses borrowings from international markets and foreign creditors, plays a pivotal role in the financing strategies of a country operating in a globalized economy. However, external debt remains one of the major economic challenges facing governments in low-income countries due to their persistence budget deficit and this has continued to attract the attention of international financial institutions and bilateral lenders (Ada et al, 2016). Moreover, along with the existence of geopolitical events, the instability created by wars, threats in the region can have far-reaching consequences on a country’s economic stability and its ability to honor its debt obligations.
For instance, recently, the Russian invasion of Ukraine has had significant effects on the hard currency emerging markets debt market. According to Lazard Asset Management (2023), the war has led to a decrease in demand and an increase in the supply of such debt, resulting in lower prices and higher yields. As a result, the index-level spread widened to approximately 500 basis points (bps), while the yield exceeded 7%. These levels are considered some ofthe most attractive since 2005.
The conflict has created a dislocation in the debt market, with investors withdrawing approximately $18 billion from the emerging markets debt asset class over the past six months, including around $10 billion in outflows in the past two months. Despite its potential significance in shaping firms' borrowing behavior and financial structure, the impact of geopolitical risk on external debt remains an understudied area of research. By properly understanding and accounting for the risks posed by shifting geopolitical conditions, nations can develop prudent policy approaches aimed at mitigating adverse 9 impacts on external debt stability and financial system resilience. A robust body of literature has illustrated how political uncertainties abroad can materially influence borrowing costs, currency valuations, trade and investment linkages for indebted economies.
With globalization intensifying interconnectedness, geopolitical spillovers must be strategically incorporated into baseline sustainability assessments and stress-testing methodologies. In this research paper, we aim to explore the intricate relationship between geopolitical risk and external debt. We will delve into various viewpoints put forth by authors regarding the mechanisms through which geopolitical risk can influence a nation's financial health, with a comprehensive focus on the implications for external debt. Through a comprehensive analysis and empirical evidence, we intend to shed light on the challenges and opportunities countries face in managing their external debt in the face of geopolitical risks.
Due to the limited data on geopolitical risk index, the scope of the study will be limited to the period from 1985 to 2021 and will focus on 17 emerging countries. This study implements 2 panel data regression models to evaluate the impact of geopolitical risks on 2 aspects of external debt (external debt level and external debt service payment) using 6 macro variables (GDP growth, Broad money, Domestic investment, GDP per capita, Inflation, Trade openess) as control variables. From there, the study contributes to a better understanding of the risks associated with a country's national debt. By studying the impact of geopolitical risk on external debt, researchers can identify the mechanisms through which geopolitical risks affect national financial stability and economic development.
This knowledge can help policymakers and financial institutions develop strategies to mitigate the negative effects of geopolitical risks on the financial system. The remainder of this paper is structured as follows. Chapter 2 examines the previous literature and develops testable hypotheses. Chapter 3 addresses the methodology, while the results will be presented and discussed in Chapter 4.
Last but not least, Chapter 5 concludes the study with implications, limitations and directions for future studies. 10 CHAPTER 2: LITTERATURE REVIEW 2. Geopolitical risk Conceptually, geopolitical risk differs from political risk of adomestic origin.