As global geopolitical tensions rise, particularly with countries whose foreign policies conflict with those of the European Union, the euro area faces significant challenges related to capital outflows and external financing, warned economists from the European Stability Mechanism, an agency specifically established to provide financial assistance to euro area countries in need. In a blog post published on Wednesday 9 October 2024, Gergely Hudecz, Alexandre Lauwers and Yasin Mimir argued that ‘geoeconomic fragmentation’ is increasing, which is detrimental not only to trade and economic activities but also to investments and debt collateral, posing hurdles to growth and financial stability in the euro area.

Capital flows

The ESM blog emphasised that over the past two decades, the euro area has deepened financial relationships with nations that are now considered ‘geopolitically distant,’ including Russia and China. These relationships now expose the region to economic vulnerabilities as geopolitical tensions increase. According to the ESM economists, the escalation of such tensions could lead to capital outflows from the euro area, impacting its financial stability.

This growing concern stems from the broader phenomenon of ‘geoeconomic fragmentation,’ where geopolitical discord affects international trade and cross-border capital flows. As per the ESM’s findings, this fragmentation has worsened over the years, with euro area financial exposures to geopolitically distant countries peaking at 60% of GDP in 2020, before declining to below 50% by mid-2023. This trend signals the ongoing fragmentation in global financial markets.

Investment vulnerabilities

According to the ESM economists, foreign direct investment (FDI) and portfolio investments have been particularly affected by geopolitical risks, with both sectors exhibiting vulnerabilities. They noted that FDI, which represents a long-term interest in foreign businesses, and portfolio investments, which focus on capital gains, have seen varying impacts across euro area member states.

While larger euro area countries tend to have substantial FDI in distant nations, smaller economies are primarily recipients of inward FDI. Recent data indicated that although euro area investors have reduced their investments in geopolitically distant countries, FDI inflows from these countries into the euro area remained relatively stable.

Portfolio investments also revealed potential exposure. According to the report, portfolio investments from geopolitically distant countries into euro area securities accounted for 8.3% of the region’s GDP. A notable portion of this is sovereign debt held as reserves by foreign central banks, with the report estimating that approximately one-third of euro area sovereign debt held by non-euro area investors is controlled by countries with differing foreign policy stances. However, this estimate carries a degree of uncertainty due to limited data.

In the second quarter of 2023, the economists estimated that foreign central banks held at least €1.26trn in debt securities issued by 11 euro area sovereigns as part of their foreign exchange reserves. Of this, about half was owned by countries geopolitically distant from the euro area. The total marketable debt securities from these sovereigns amounted to €10.3trn, with €1.9trn held by non-euro area residents. Though central banks from distant countries represent only 6.2% of all investors in euro area sovereign debt, they hold a significant 33% of these assets among non-euro area investors.

Portfolio investments

The blog argues that rising geopolitical tensions would likely lead to a reduction in portfolio investments between countries with differing political stances. Empirical evidence supported this, said the three economists, showing that investor nations tend to allocate smaller investments to partners with contrasting foreign policy views. The impact was especially pronounced for euro area portfolio investments.

According to the ESM’s estimates, if geopolitical distance between countries were to increase, portfolio investments into the euro area could decline by 1.5% of GDP, with equity and debt securities affected by 0.8% and 0.7% of GDP, respectively.

While private portfolio flows are particularly sensitive to geopolitical changes, the potential outflows are considered moderate due to the relatively small exposures. In contrast, official reserve holdings are less reactive to geopolitical shifts, yet the adverse impact on sovereign financing could be economically significant, given the large scale of these reserves. Additionally, euro area investors could liquidate their portfolio claims in geopolitically distant countries, which could amount to a further 2.1% of euro area GDP.

Currency reserves

The composition of foreign exchange reserves is another area where geopolitical factors can play a role. The economists offered anecdotal evidence suggesting that some central banks have started diversifying their reserves away from assets linked to geopolitically distant countries. According to their analysis, reserves denominated in euros could be more vulnerable to geopolitical shifts than those in US dollars.

Portfolio flows

Adverse geopolitical events can also influence portfolio flows between the euro area and the rest of the world. Historically, the euro area has been viewed as a safe haven, attracting net portfolio inflows during periods of instability. The blog noted that in times of geopolitical shocks, euro area investors often pull back from foreign equities, while foreign investors increase their purchases of euro area equities, creating net equity inflows. Furthermore, the search for safer assets frequently results in inflows into euro area debt securities, provided that geopolitical risks remain contained.

However, the ESM economists warned that when geopolitical risks are heightened, portfolio debt inflows can become volatile, potentially leading to outflows from the euro area. This would exacerbate the region’s external financing challenges, further stressing its financial stability.

Diversification and risk-sharing

In light of rising geopolitical risks, the ESM economists concluded that financial shocks to the euro area are likely to become more frequent and severe. They argued against isolationism, warning that the euro area would suffer significant losses if globalisation were reversed and financial markets became fragmented. Such an outcome would make financing more expensive and difficult to secure.

Instead, they suggested that the euro area should focus on diversifying its global financial connections to reduce the impact of financial shocks. Domestically, strengthening mechanisms for risk-sharing, such as the ESM, banking union and capital markets union, would enhance the euro area’s resilience against increasing global volatility.

The blog post was part of a discussion paper by the ESM, created in collaboration with Amro, the Asian Monetary Fund. The 99-page discussion paper was also published on 9 October 2024 and is available here.