Opinion Leader: Fei Wu, Professor at Shanghai Advanced Institute of Finance, Shanghai Jiao Tong University
Recently, the conflict between Russia and Ukraine has been a matter of wide concern all over the world. Many economists and Key Opinion Leaders in China have different views about the impact of the recent Russia-Ukraine conflict upon the global economy and financial markets.
However, there is nothing new under the sun. The impact of regional political crises on financial markets, especially capital markets, has been widely studied in academic circles. From the perspective of financial research, I try to summarize the empirical findings about the impact of political crises on global financial markets in the academic community in terms of several major topics. Topic 1: Sources of political risks Key findings: Historically, US leaders with poor economic performance are more likely to start wars
People are highly concerned about how the recent Russian-Ukrainian conflict broke out, and what forces behind it are boosting and influencing its evolution. There is a voice in the market whispering that the United States is the key contributor behind this crisis. Is the United States motivated to contribute to the conflict or trigger the war? Some scholars have studied this topic and given their perspectives.
An article on US war politics published in American Economic Review indicates that the incumbent president who performs poorly in economic growth may want to consolidate his political position by waging a war, thus gaining a favorable impression in the election. This is not uncommon in US history. Various considerations include: reducing domestic economic pressure through war, driving the transfer of talent and funds through regional politics, military industry and safe-haven capital inflow, and influence leaders' attitudes towards geopolitics and war.
Judging from the current impact of the Russo-Ukrainian War, the US announced sanctions against Russia, which also aggravated geopolitical uncertainty on the European continent. It may prompt European safe-haven capital to flow into the US markets and offset the potential bubble bursting and market downside risks caused by the Fed's interest rate hike. Based on this logic, the Biden administration has enough motivation to "contribute" to the Russo-Ukrainian crisis, so as to cover up domestic criticism of its economic management.
Topic 2: Impact on the price of financial assets Key findings: It has a negative impact on asset prices and volatility
I think most people will be concerned that once a conflict occurs, the financial markets will react immediately, and the prices of financial assets will change. But how does a conflict affect asset prices? And why?
In 2011, the Journal of Financial Economics published the first article on the impact of global political crisis on stock markets based on the International Crisis Behavior database. This paper uses a sample of 447 international political crises from 1918 to 2006 – including political opposition, military conflicts and even major wars – and reports several findings about the impact on stock markets.
First of all, the changing political crisis probability significantly affects the averages and volatility of global stock market returns. On average, global stock markets, during a political crisis, have yielded 4% less annualized than normal, and the figure is even larger for countries involved in the crisis. This is consistent with the sharp decline of the Russian stock market in the current conflict. This observation shows that investors are very sensitive and concerned to politics-related catastrophic risk or tail risk, and the political crisis also increases the volatility of stock prices.
Second, because of fears of catastrophic risk, the risk of political crisis will also affect investors' expected returns in the future. Stocks in industries that are more sensitive to political risk expect higher returns, because investors demand higher returns as compensation for holding these risky stocks.
In addition, the types and degrees of political crises have different influences upon stock markets. Political crises involving regional threats, local kinetic conflicts (such as the Russo-Ukrainian War) and even human survival will lead to great declines of stock prices. Especially when a superpower intervenes in the political crisis and the crisis is continuously prolonged, the negative impact will become more severe, and it may even affect consumption and GDP growth in the real economy.
The impact of political crisis on financial markets is also reflected in bond markets. I participated in a paper published in the Journal of Banking and Finance, which used data from 109 international political crises between 1988 and 2007 to study the impact of crisis events on the prices of bonds issued by 34 governments involved in crises. Our observations show that during crises, the price of government bonds in the involved countries fell, which made the bond yields rise. However, a stable political system and a good investor protection system can alleviate the impact of political crises on bond prices.
Topic 3: Impact on enterprises Key findings: Listed companies tend to be financially conservative — with decreased leverage, more cash held, and a conservative dividend policy
In the past context of globalization, listed companies participated in global economic activities more or less, and their markets, supply chains and financial activities were often closely related to rest of the world. Therefore, listed companies are very sensitive to regional political risks, especially in industries having a high correlation with political risks.
A study of multinationals, also published in the Journal of Financial Economics, shows that companies that invest in countries with political risks have greater stock price volatility. In response to political risk, multinationals typically reduce corporate leverage: on average, a standard deviation of political risk corresponds to a 3.5% reduction in leverage. That is to say, the higher the political risk, the lower the willingness of enterprises to use leverage.
I participated in a paper published in the Journal of International Business Research, which also used data from International Crisis Behavior; it found that global political crises will increase the uncertainty of financial markets and the external financing costs of enterprises. In an uncertain environment, listed companies are less willing to pay dividends in order to keep cash in reserve. This phenomenon is particularly obvious in multinationals. A stable national financial system and more sound legal protection for investors would help alleviate this situation.
Although these samples included Chinese companies, the same results were found in papers that directly studied Chinese samples. A paper published in Pacific-Basin Finance Journal reports that Chinese companies also tend to hoard cash as a precaution when faced with geopolitical risks. For example, when the Sino-US trade war broke out, Chinese manufacturers tended to reserve more cash as a buffer against geopolitical risks. This phenomenon is more visible in companies with weaker financing capacities.
Political risks have different impacts on different industries. A paper published in Financial Research Review points out that when regional political risks are high, industries show greater stock price volatility when they are more dependent on trade, more sensitive to contract enforcement, or closely connected to their labor force. Although enterprises depending on international trade may be able to diversify political risks by optimizing the choice of trading partners, the risk diversification effect is extremely limited.
What do these findings tell?
1. The impact of regional political crisis on financial markets is definite and negative.
Quantitative studies of modern historical data show consistent and remarkable findings on the impact and results of political crises similar to the Russia-Ukraine conflict. The impact of the political crisis upon global financial markets is obvious, as we have observed and expected.
First of all, the crisis has a negative impact on asset prices in financial markets and increases price volatility. Because the financial markets play the resource allocation and financing role, the impact of the crisis will increase the financing cost of markets and reduce the efficiency of resource allocation.
For the real economy, the political crisis will lead companies to adopt more conservative financial policies and become unwilling to expand and invest in business, which will definitely have a negative impact on economic growth at the national level. The impact may extend to the expectation of global economic growth, especially increasing the uncertainty on whether the global economy can soon emerge from the COVID-19 pandemic.
2. The institutional quality of a country will play an alleviating role.
The degree of impact of political risk on asset prices and the real economy is related to the institutional quality of a country.
First of all, the impact of regional conflicts shows industry differences. Not all industries depend on the institutional environment equally, so the impact of the crisis on industries varies. For example, the volatility of stock prices in industries that rely too much on a contract enforcement environment rather than long-term partnerships is more affected.
Second, the impact of uncertainty risks caused by political crises on bond prices has been alleviated in some countries with more stable politics and better investor protection. Meanwhile, a stable national financial system and a more effective legal protection mechanism for investors will also help to alleviate the negative impact of political crises on corporate financial behavior.
Direct findings also indicate that political crises, such as terrorist incidents, have a significant negative impact upon economic growth, but such impacts are more obvious in developing countries than in developed countries. Risk-adverse investors of capital and talent, in times of conflict, are more inclined to seek mature markets and more stable polities and economies. Generally speaking, developed countries stand more to gain from conflicts. Conversely, how to avoid negative effects in times of conflict has become a critical challenge for developing countries.
1. Long-term effects
In short, the current political crisis has increased the concern of participants in financial markets, such as investors and listed companies, about the uncertainty of the future. Investors' expectations for investment return will change accordingly. The real economy tends to be conservative because of uncertainty and is unwilling to invest. Individual consumers will also reduce their consumption when faced with uncertainty. Taken together, these effects are enormous. But what is more noteworthy is that such effects may not disappear in a short time, and long-term hazards may instead be more worthy of attention.
Political crisis can also lead to a change in the direction of economic activities, which shift from investment expenditure to more government expenditure. The reason that the United States uses war as a means to adjust its domestic economy is that it can increase government expenditure and transfer resources to military, energy, and other related industries. In the medium and long term, the conflict between Russia and Ukraine will inevitably affect the direction of economic activities, shifting from investment expenditure to government expenditure. Meanwhile, a large number of resources will be allocated to sectors related to the conflict (national defense, energy, information technology) — with private investment also be affected by the "crowding out effect".
Therefore, the Russo-Ukrainian War is a major political crisis in which superpowers have participated. In the short and medium term, the impact on the volatility and profitability of the global stock market will probably be more severe than the previous local skirmishes. With the continuation of the conflict and the prospect of a long-term recovery afterwards, we should pay more attention to the negative effects on medium and long-term global economic growth.
2. Precautions prior to a crisis
After the conflict between Russia and Ukraine, the Russian stock market plummeted, but then the government stopped the trading. In view of the strong negative impact of major political crises on markets in history, should the Russian government have planned for the stock market fall before taking action? It is a question worthy of our attention. After all, the stock market crash affects not only the wealth of individuals and the value of listed companies, but also the confidence of entire financial markets.
3. Optimization of system design to mitigate the impact of crisis
As we discussed earlier, studies find that the institutional quality of a country will play a role in alleviating the impact of a crisis. A political crisis affects financial markets mainly by changing participants' uncertainty perception and confidence, which means that maintaining market confidence is an important means by which to resist the impact of a crisis. Therefore, the design of this system may focus upon the confidence of market participants.
For the special design of China's financial system, the "national team" of large state-owned financial institutions, state-owned enterprises and stock markets will play a role in the overall stability of the financial markets. In addition, by strengthening the design of an investor protection mechanism and enhancing the confidence of other investors in the market, the impact of a crisis can be alleviated, which has been verified in academic studies.
(Author Profile: Professor Wu currently serves as a Professor of Finance at the Shanghai Advanced Institute of Finance, focusing on behavioral finance and private (family) wealth management. From 2004 to 2010, he taught at Massey University in New Zealand. He was formerly Director of the Asian Finance Association and was Special Editor of Economic Systems.)