ECO 5 Introduction to Geopolitics

Geopolitics is the study of how geography shapes politics and international relations. Analysts in this field study actors, that is, the people, organizations, businesses, and governments that conduct political, economic, and financial activity, along with the way they interact. Investors care because these relationships move the drivers of returns: how fast economies grow, how businesses perform, how volatile markets are, and how costly transactions become. The aim of this reading is a framework for measuring, tracking, and reacting to geopolitical risk.

State and non-state actors

Actors fall into two groups. State actors are national governments, political bodies, or the leaders of a nation who hold authority over its security and its resources, for example a prime minister, a parliament, or a head of state. Non-state actors join in worldwide political, economic, or financial life without directly controlling a nation’s security or its resources; they include non-governmental organizations, multinational companies, charities, and prominent figures such as business leaders or cultural icons.

Actors are shaped not only by their direct dealings but also by the ties of their allies and rivals. Suppose Country A cooperates with Country B. If B then strikes Country C, which is a close ally of A, the tie between A and B may sour or break. Cooperation running through many channels can also build trust over years. The result is a web of relationships that shapes events, decisions, and market outcomes, so categorizing the threats and opportunities a country faces helps gauge how likely geopolitical risk is to surface.

Features of political cooperation

Relations between state actors can be cooperative or competitive. Cooperation is the way nations act jointly in pursuit of a common purpose, and those purposes vary widely, from military and strategic aims to economic influence and cultural preference. Political cooperation specifically is the degree to which countries reach agreement on rules and standardization for their interactions.

A cooperative country engages and reciprocates: it takes part in rules standardization, tariff harmonization, and agreements on trade, immigration, or regulation, and it permits information to move freely, technology transfer included. A non-cooperative country runs inconsistent or arbitrary rules, restricts the movement of goods, services, people, and capital, retaliates, and limits technology exchange. The two poles sit at opposite ends of a spectrum rather than being fixed categories.

A country chooses to cooperate for reasons rooted in its national interest, its goals and ambitions, which may be military, economic, or cultural.

• National security interest. National defense protects a country, its citizens, economy, and institutions from external threats, which may be military attacks, terrorism, crime, cyber intrusions, or even natural disasters. Geography matters here: a landlocked country such as Switzerland leans on its neighbors for access to vital resources, which raises the value of cooperation, while a country sitting astride major trade routes, such as Singapore, or acting as a trade conduit, such as Panama, can turn its location into a lever of power.
• Economic interest. National security has widened to take in economic factors such as access to energy, food, and water. Cooperating countries usually pursue one of two aims: securing essential resources through trade, or leveling the playing field for their own firms through standardization.

Resource endowment, standardization, and soft power

Cooperation is further shaped by three influences. First, geophysical resource endowment, meaning livable geography and climate plus access to food and water, is spread very unequally. A few, among them China, Australia, Russia, and the United States, are fairly self-reliant; others, including Western Europe, Japan, and Turkey, lean heavily on outsiders for inputs such as fossil fuels; and some, such as Saudi Arabia, are rich in one resource but reliant on others for basic needs. A country rich in a scarce resource gains leverage over a country that needs it, although unequal internal gains from that resource can breed instability.

Second, standardization means building protocols that govern how a good or service is produced, sold, transported, or used, taking effect once the relevant parties agree to follow them together. It lowers the cost of cross-border trade and capital flows and can be driven by non-state bodies such as industry groups. Familiar examples include the Basel Committee on Banking Supervision, founded in 1974 by the G-10 banking supervisors and later widened to the G-20; SWIFT, set up in 1973 to carry global payments across more than 200 countries and territories; and containerization, the agreement on uniform container sizes that cut the time and cost of shipping.

Third, cultural ties and soft power matter. Soft power is a means of influencing another country’s choices without force or coercion, built over time through cultural programs, advertising, travel grants, and university exchange. The European Union Erasmus+ program funds education and sport exchanges, and South Korea advertises its capital and cultural exports in transit systems worldwide to draw people toward Korean culture and business.

Institutions and the hierarchy of interests

An institution is a settled organization or practice, whether formal (a university, a law-backed process) or informal (customs, behavioral norms). Strong institutions, including those that promote accountability, rule of law, and property rights, make internal and external politics steadier, which gives a country more room to forge lasting cooperative ties and lowers the chance it walks away from them.

A country’s national interest can be pictured as a hierarchy, with survival needs at the top and nice-but-not-essential items lower down. Governments use this ranking to guide behavior: they cooperate where it helps the nation, but when two needs demand conflicting tactics, the higher-ranked need wins. Tariff harmonization may help a country on its own, yet if that country is in military conflict with its trade partner, and military determination sits higher on the hierarchy, cooperation may no longer serve the national interest. Priorities also shift as leaders change or global events unfold. The length of the political cycle matters too: where terms run only a few years, long-horizon issues such as climate change or income inequality are hard to prioritize against goals that can be delivered quickly.

Non-cooperation is the far end of the spectrum. It is rare, partly because other actors have an incentive to coerce a holdout back into cooperation. Venezuela is an example: concerns over narcotics trafficking and a lack of counterterrorism cooperation led the United States, later joined by the European Union, to impose targeted sanctions, including restrictions on officials, blocked financial transactions, and an oil-sector embargo. That Venezuela accepted the resulting hardship signals that its political self-determination ranks above the humanitarian cost to its citizens.

Globalization is the growing interaction and integration of people, companies, and governments across the world, seen in the movement of products, information, jobs, and culture over borders. One common gauge, the World Bank Openness Index, climbed from 27 percent back in 1970 to above 60 percent by 2019. Since 2008 it has met headwinds: the Global Financial Crisis raised scrutiny of cross-border activity, rising nationalism cut some countries’ appetite for imports, and capacity constraints cap how far trade can expand, since trade cannot become 100 percent of global activity.

The pattern shows up at the micro level too. A single car may be designed in Japan, carry electrical parts from Germany, a steering system designed in the United States, seatbelts from Sweden, and a climate system from Belgium, then be assembled in Mexico, finished in one country, and sold in a third. Such supply chains let firms hunt for the best inputs by quality or cost and open opportunities for investors across engineering, production, and logistics. Culture spreads the same way, from a Warsaw grocery stocking Italian cheese and Colombian coffee to social media collaborations across continents.

Globalization versus nationalism

Where political cooperation is mostly the work of state actors, globalization springs from economic and financial cooperation and is driven mostly by non-state actors: corporations, individuals, and organizations. It shows up as active trade in goods and services, movements of capital, currency exchange, and the sharing of culture and information. Its opposite, antiglobalization or nationalism, advances a nation’s own economic interests at the expense of others, and shows up as limited trade, restricted capital flows, and tight currency exchange. Globalization and political cooperation tend to move together, yet globalization is also an independent force: private-sector activity can drive the exchange of products and ideas even without government support.

Motivations for globalization

Non-state actors that choose to globalize weigh three potential gains.

• Increasing profits. Profit rises by lifting sales or cutting costs. Reaching new customers abroad may require building property, plant, and equipment and hiring locally, while access to lower taxes, cheaper labor, or supply-chain efficiencies reduces cost. The two often combine: consolidating a capital-intensive industry such as automobiles spreads fixed costs over more units, so producers gain global sales while cutting cost per unit.
• Access to resources and markets. Firms may globalize to secure talent or raw materials not available or affordable at home, or to reach foreign markets. Two flows matter for investors: portfolio investment flows, the short-term holding of foreign stocks or bonds, and foreign direct investment (FDI), the long-term investment in the productive capacity of another country.
• Intrinsic gain. This is a benefit beyond profit, such as personal growth, education, or faster productivity from learning new methods. It is hard to measure but adds momentum and can stabilize relations by building empathy between actors.

Reducing barriers between businesses also yields broad benefits: more choice, higher quality, sharper competition, greater efficiency, and increased labor mobility.

Costs and threats of rollback

Globalization also carries costs. Aggregate gains do not mean gains for everyone: moving a factory abroad creates jobs in one place and cuts them in another. Firms operating under weaker local standards may lower their environmental, social, and governance practices, so measured profit rises while overall welfare falls. These strains feed a third cost, political backlash, which can widen inequality within and between countries and become a force for rolling back cooperation. Finally, deeper cooperation breeds interdependence: rare earth metals come largely from China and copper largely from Chile, so a mining accident, flood, or political dispute can disrupt whole industries. The COVID-19 pandemic showed this vividly, as semiconductor shortages concentrated in a few producers rippled from automobiles into many other industries.

Talk of deglobalization grew after 2018, when a series of nationalist trade policies escalated tariff disputes that eventually reached long-standing allies. Even so, a full reversal looks unlikely. Multinationals are used to political and operational risk and are slow to redraw carefully engineered processes over disputes that may pass. Instead, firms tend to fortify supply chains with a mix of three tactics:

1. Reshoring the essentials: rebuilding critical supply chains, such as medicines and protective equipment, at home for emergencies.
2. Reglobalizing production: duplicating or reinforcing supply chains across locations to cushion disruption.
3. Doubling down on key markets: keeping production in large markets where size, infrastructure, rising worker productivity, and the cost of rebuilding elsewhere make relocation impractical, often producing in country, for the country.

During the 1930s Great Depression, countries raised trade barriers, devalued currencies to compete for export markets, and limited citizens’ access to foreign exchange. These moves backfired, world trade collapsed, and living standards fell. By the 1940s it was widely accepted that the global economy needed institutions to promote cooperation. In July 1944, at the Bretton Woods conference on monetary and financial affairs convened by the United Nations, delegates from 45 governments settled on a framework. Two bodies emerged: the World Bank, created at the conference itself, and the International Monetary Fund (IMF), which formally came into being in December 1945.

A planned third body, the International Trade Organization, never launched, because ratification failed, most importantly in the US Congress, and in 1950 the US government dropped it. In its place, the General Agreement on Tariffs and Trade (GATT), signed on 30 October 1947 by 23 nations, served as the sole multilateral instrument for cross-border trade between 1948 and the launch of the World Trade Organization (WTO) in 1995.

The International Monetary Fund

The IMF is prepared to lend foreign currencies to members during spells of large external deficits, drawing on a reserve of gold and currencies that members supply. Loans come with strict conditions, and borrowers’ macroeconomic policies are monitored continuously. Its central mandate is to protect the stability of the global monetary system, the network of exchange rates and payments that lets countries buy goods and services from one another. More specifically, the IMF offers a venue for cooperating on monetary problems, supports the growth of trade and employment, backs exchange-rate stability and open payments, and lends foreign exchange on a temporary, safeguarded basis to help members manage balance-of-payments problems.

After the 2008 to 2009 Global Financial Crisis, the IMF deepened its work: it enhanced and streamlined its lending facilities and roughly doubled members’ access to resources, improved surveillance of global, regional, and country economies, helped resolve global imbalances, expanded analysis of capital markets, and joined the World Bank in assessing financial-sector vulnerabilities. From an investment view, it helps hold country-specific and broad systemic risk in check.

The Greek sovereign debt crisis illustrates this role. In early 2010, Greek debt was cut to non-investment grade over doubts about the sustainability of its public debt, built up through elevated spending on public jobs, pensions, and benefits, persistent tax evasion, and misreported statistics. Yields spiked, other European bonds fell, and equity markets dropped on contagion fears. Facing default, Greece requested a joint European Union and IMF package: an immediate EUR45 billion in 2010 within a total of EUR110 billion, tied to strict conditions including wage and benefit cuts, a higher retirement age, pension limits, tax increases, and shrinking state-owned enterprises. By providing conditional lending, the IMF headed off a wider wave of sovereign crises. It played a similar rescue role in the East Asian financial crisis that began in July 1997 when Thailand abandoned its dollar peg.

The World Bank Group

The World Bank exists chiefly to help developing nations reduce poverty and pursue environmentally sound growth. To grow and attract business, such countries need stronger governments and trained officials, business-friendly legal and judicial systems, protected property and contract rights, robust financial systems, and less corruption. The Bank supplies funds, financial expertise, and technical advice toward these goals.

Two affiliated entities do much of the lending. The International Bank for Reconstruction and Development (IBRD) is market-based and uses its top credit rating to pass low borrowing costs on to developing-country borrowers, covering its own operating costs; its lending is financed largely by selling AAA-rated bonds, and its capital comes from reserves and contributions of its 185 member shareholders. The International Development Association (IDA) ranks as the largest single provider of interest-free loans and grants to the poorest countries, topped up on a three-year cycle by 40 donor countries and through repayments on no-interest loans of 35 to 40 years. At the end of September 2010, IBRD net loans outstanding were USD125.5 billion against borrowings of USD132 billion. For investors, the Bank builds the basic infrastructure that domestic financial markets need, and the IBRD itself is a major, highly rated supranational borrower whose bonds are widely held.

The World Trade Organization

The WTO supplies the legal and institutional backbone of the multinational trading system; it is the one international body regulating cross-border trade among nations worldwide. Founded on 1 January 1995, it replaced the GATT, which had governed trade since 1947 through several negotiating rounds, notably the Tokyo round, the first broad attack on non-tariff barriers, and the Uruguay round, which extended the system into services, intellectual property, agriculture, and textiles. An updated 1994 GATT remains the WTO’s principal treaty for goods, and together with the General Agreement on Trade in Services (GATS), in force since January 1995, it anchors a body of roughly 60 agreements.

The most recent round opened in Doha in November 2001, aiming to cut barriers and subsidies in agriculture and services. No final deal was reached, but the period included China joining the WTO in December 2001, and the stalemate encouraged a rise in bilateral and regional agreements. The WTO implements and administers agreements, hosts negotiations, settles disputes, reviews members’ trade policies, and supports developing countries. For investors, its rules make today’s global multinational corporations possible, and modern portfolios of their stocks and bonds would look very different without them.

Two axes organize the analysis: political cooperation set against non-cooperation, and globalization set against nationalism. Plotting a country on both axes yields four archetypes of behavior, each with its own costs, benefits, and trade-offs for geopolitical risk. As a general rule, regions, countries, and industries more reliant on cross-border flows of goods and capital gain more from global cooperation, and their interdependence lowers the chance that partners attack one another. Yet that same interdependence often leaves cooperative actors more exposed to geopolitical risk, because diversified production adds touchpoints where risk can strike.

Both axes are spectrums, and few countries sit at a pure extreme. A country’s position can also move over time, so what matters for analysis is not only which quadrant a country occupies today but how stable it is there. A hegemon working to build cooperation may pose less threat to returns than a multilateral actor working to unwind it.

The four archetypes

• Autarky is the stance of countries pursuing political self-reliance while doing little or no trade or finance abroad, with state-owned enterprises running strategic industries. Self-sufficiency can strengthen political control and, at times, speed development, as China’s largely autarkic 20th century preceded major poverty reduction. It can also stall progress, as in North Korea and Venezuela.
• Hegemony describes regional or global leaders that use political and economic influence to control resources, often with state-owned enterprises dominating key export markets. Aligning countries can enjoy the stability of the leader’s enforced standards, but as a hegemon gains or loses influence it may turn more competitive, raising risk.
• Multilateralism describes countries in mutually beneficial trade relationships with extensive rules harmonization, whose private firms are fully woven into global supply chains with many partners. Germany and Singapore are examples.
• Bilateralism is cooperation between two countries at a time. A bilateral country may deal with many partners, but through one-at-a-time agreements. Between bilateralism and multilateralism sits regionalism, where a group of countries cooperate, sometimes to the exclusion of outsiders. Few countries fit the pure bilateral mold, since stronger cooperation tends to slide organically into globalization; Japan once fit it but is now considered multilateral.

Illustrations of the framework

China and technology transfer (hegemonic tilt). China passed Japan to become the second largest economy on earth in 2011, having joined the WTO in 2001. Its size let it require some foreign firms to transfer technology to Chinese partners in exchange for access to its labor supply and market. This spreads international know-how, a globalizing effect, but a more restrictive turn could disrupt global supply chains and raise costs.

Russia and gas disputes (autarkic tilt). Russia’s oil industry is deeply woven into global supply chains, yet the country stays politically autonomous. Its control of major gas pipelines gives it leverage over European buyers, who may hesitate to confront it. When Russia annexed Crimea between February and March 2014, condemned as a violation of international law and of earlier agreements such as the 1991 Belavezha Accords, the ruble fell sharply, volatility and inflation rose, and Canada, the United States, and European Union members imposed sanctions, while the annexation persisted partly because few wanted to sever the economic tie.

Singapore (multilateral). Singapore ranks among the most open, least corrupt, and most pro-business economies in the world, with low tax rates and very high GDP per capita in purchasing-power terms. Its scarce natural resources force reliance on trade and innovation; its position at the crossroads of major trade routes, its ethnically diverse and English-speaking workforce, and its stable, business-friendly institutions make it an attractive partner. The openness that lifts its growth also leaves it more exposed to geopolitical risk than less trade-dependent countries.

Sources: World Bank, Transparency International, KPMG, International Monetary Fund.

Actors use tools to advance or defend their interests, and those tools are the ultimate source of the geopolitical risk that reaches investors, shaping how likely a risk is and how fast and how large its impact will be. The tools fall into three kinds: national security, economic, and financial. Within each type, some choices deepen cooperation by increasing flows of goods, services, capital, or labor, while others escalate conflict by cutting those flows. The mix an actor chooses helps place it within the four-archetype framework and signals whether its character is shifting.

National security tools

These sway or pressure a state actor through direct or indirect effects on its resources, its people, or its borders, and they may be active or merely threatened. The most extreme is armed conflict, a direct and active tool that can destroy physical infrastructure, damaging a country’s capital stock for the long term, and can drive migration that reshapes flows of goods, services, capital, and labor and burdens neighboring states.

The Syrian refugee crisis, which began in March 2011, shows both effects. Civil war devastated Syria’s infrastructure, more than 6.6 million people fled and 6.7 million were internally displaced, and an economy that had expanded on average 4.5 percent a year between 2000 and 2010 shrank to less than half its pre-war size by 2016, feeding a higher discount rate and weaker returns. Many refugees reached Europe, and in 2015 Germany announced it would admit 1 million Syrians. Disruptive in the short term, the decision appears to have helped Germany over the long term by attracting younger, skilled migrants that improved the demographic balance of an aging country, lifting its potential growth and expected market returns.

Not every national security tool is so direct or so hostile. Espionage, the use of spies to gather political or military information, is an indirect tool. Military alliances can support conflict but also deter it: the North Atlantic Treaty Organization (NATO), originally built for collective security against the Soviet Union, now serves cooperatively to defuse conflict among members and outsiders and to limit nuclear proliferation.

Economic tools

Economic tools reinforce a stance through economic means. Cooperative versions include multilateral trade agreements such as MERCOSUR in South America, tariff harmonization through the WTO, common markets such as the European Union, and a shared currency such as the euro. Non-cooperative versions include nationalization, the transfer of an activity from private to state control, most common in sectors seen as vital such as energy; Argentina renationalized YPF, its largest energy firm, in 2012 to secure fossil-fuel revenue and foreign exchange. Countries may also use voluntary export restraints, trading less than demand would support, or domestic content requirements, mandating a share of domestic inputs in exported goods.

Financial tools

Financial tools work through financial mechanisms. Cooperative examples include freely exchanging currencies across borders and permitting foreign investment; non-cooperative ones include capping access to local currency markets and curbing inbound investment, with sanctions a prominent case. Cooperative financial tools can lower geopolitical risk, but they can also create vulnerabilities when the system leans too heavily on one of them.

Multifaceted approaches

Political, economic, and financial cooperation often intertwine. Cabotage, the right of a foreign firm to move passengers or goods within a country, is frequently restricted even among trade partners, because permitting it requires coordination on security and economics at once. International organizations combine tools as well: the Association of Southeast Asian Nations (ASEAN), with 10 member states, pursues economic, political, security, military, educational, and cultural integration, and the European Union, which started life as an economic bloc of six countries, had grown to 27 members by 2022 with substantial financial and security dimensions. The more tools of collaboration an actor adopts, the less likely it is to turn a non-cooperative tool on its partners.

The European Union illustrates a long march toward cooperation, from the 1950 European Coal and Steel Community through the removal of customs duties, the single market, European citizenship, and a common currency for the euro area. That momentum met a marked disruption in 2016 when the United Kingdom voted to leave, producing near-term volatility in financial and currency markets and a partial shift from a multilateral toward a bilateral approach.

These tools do not act in a vacuum. In the classic account of trade, countries specialize according to their resources and capabilities and then exchange, gaining economies of scale, more variety, sharper competition, and more efficient use of resources; Ghana, for instance, is rich in hydrocarbons, gold, and metals but relies on others to process them. Geopolitical risk can tilt this comparative advantage: countries with low risk exposure may attract labor and capital, while high-risk countries may lose them, and a persistent threat of conflict can raise volatility and the required rate of return investors demand.

How far investors build geopolitical risk into decisions varies with their objectives and risk tolerance. Some are takers of geopolitical risk, weighing it only where it affects the long-term appeal of an asset class. For others it is central, and monitoring dislocations becomes a source of alpha: an investor expecting a political transition might hedge against volatility or treat the volatility as a buying opportunity.

Three types of geopolitical risk

• Event risk revolves around set dates known in advance, such as elections, new legislation, holidays, or political anniversaries, so analysts use political calendars as a starting point. The United Kingdom referendum of 23 June 2016 is an example: the date and stakes were clear well beforehand, yet most investors expected the vote to keep EU membership, and the opposite result sharply changed expectations.
• Exogenous risk is sudden or unanticipated and can strike a country’s willingness to cooperate, the capacity of non-state actors to operate across borders, or both. Examples include sudden uprisings, invasions, and the aftermath of natural disasters, such as Japan’s 2011 earthquake and tsunami.
• Thematic risk is a recognized risk that builds and widens over time, such as climate change, migration patterns, populism, terrorism, and cyber threats. Cyber risk, for instance, has grown steadily in scale, with records affected now numbering in the billions per year.

The Brexit vote hit equities, the pound, and gilts at once; equities recovered but the pound kept sliding as investors weighed weaker long-run growth. The Fukushima disaster of 11 March 2011 pushed Japanese equities down as much as 20.4 percent by late November 2011 and shifted policy, with Germany deciding to phase out nuclear power by 2022 and Belgium by 2025. The Equifax breach of September 2017 exposed the data of roughly 147 million people and sent the stock down 13.7 percent in a day, yet the broader industry was little affected at first, showing how a discrete impact can stay contained.

Assessing a threat: likelihood, velocity, and impact

To decide whether a risk matters for a portfolio, an investor weighs three things together.

• Likelihood is the probability the risk occurs, often more art than science. The framework helps: highly cooperative, globalized countries face lower odds of partners inflicting risk, because the cost of doing so is higher, but their interconnectedness can make them more vulnerable when risk does arrive.
• Velocity is the pace at which a risk hits a portfolio. High-velocity, black-swan events cause short-term volatility and flight to quality, prompting tactical shifts; medium-term risks impair specific sectors’ costs and valuations; low-velocity risks affect long-run asset allocation with limited immediate impact. Some risks, such as Brexit, act at more than one speed.
• Impact is the size and nature of the effect. It can be discrete, touching one company or sector, or broad, felt across a country or the global economy, and it tends to be larger when markets are already contracting.

From assessment to action

Because risks seldom develop in a straight line, many investors turn to scenario analysis instead of one point forecast. Scenario analysis evaluates portfolio outcomes across possible states of the world, qualitatively, quantitatively, or both, starting from a base case and adding upside and downside paths. It also demands guarding against groupthink, where teams reading similar research reach similar conclusions.

Teams then follow priority risks through signposts, meaning indicators, market levels, or events that flag whether a risk is growing more or less probable. A useful rule for telling signal from noise turns on separating politics from policy: political theater may move headlines, but it is shifts in policy that create durable portfolio impacts. Combinations such as high inflation with worsening employment, or a pegged currency with collapsing export values, often warn of trouble before official data confirm it.

Finally, geopolitical risk research must translate into action suited to the investor. Asset allocators may tilt toward reliable multilateral countries and away from those under constant military threat; portfolio managers may treat geopolitical exposure as a factor in multifactor models. A long-horizon investor might view an exogenous shock as a buying opportunity, while the same shock could badly hurt an investor near retirement. The Geopolitical Risk Index (GPR), built in a 2019 paper by two US Federal Reserve Board of Governors analysts from a tally of news coverage of geopolitical tensions, found that high geopolitical risk lowers US investment, employment, and stock prices, that firm-level investment falls most in exposed industries, and that the threat of adverse events carried a larger impact over time than the events themselves.