Borrowing From Friends: Geopolitics and the Limits of Risk-Sharing
When geopolitical risk increases, countries borrow more from their friends, which hinders the insurance benefits of official lending. A commentary by Giovanni Rosso
International macroeconomics has traditionally modelled capital flows as driven by economic fundamentals. In a world of increased fragmentation, however, geopolitical forces might matter just as much.
In a new paper, with Javier Bianchi, Sebastian Horn and César Sosa-Padilla, we study this phenomenon systematically over a 115-year sample, through the lens of bilateral official lending – loans from one government to another.
This is a useful setting because governments directly control these flows, and because the creditor and debtor are observed country pair by country pair.
Our dataset covers roughly $9 trillion (in 2015 constant USD) in bilateral lending between 120 creditor governments and 190 debtor governments from 1910 to 2024, allowing us to study not only the recent period but also the world wars, the Cold War, and the post-1990 era of globalisation.
We start by documenting empirically that bilateral lending relationships indeed co-move with geopolitics. We construct an index of “financial fragmentation”, based on bilateral lending flows and alliances. Higher values of the index identify periods in which lending is concentrated within geopolitical blocs.
Conversely, negative values indicate more diversified lending relationships. We find that this index strongly co-moves, both at the global level and at the country level, with geopolitical risk.
Why? In periods of heightened geopolitical risk, one might want to strengthen financial ties with one’s trusted partners.
However, sovereign lending and borrowing is a form of insurance. That is, it allows countries to smooth consumption and economic conditions in the face of shocks. Here comes the problem.
We show that politically aligned countries tend to have much more synchronised business cycles than rivals, measured by bilateral correlations of either realised consumption growth or forward-looking consumption risk.
This holds even after controlling for intuitive common explanatory factors, like geographic proximity, common languages, common history or bilateral trade exposure.
Naturally then, if lending tilts towards friendly countries, this reduces the scope for risk-sharing. In other words, friends are not the most efficient providers of insurance if they tend to be exposed to positively correlated shocks.
Why would countries then do this? To rationalise this phenomenon, we develop a theory that emphasises the borrower’s reasons. We build a two-period model of sovereign borrowing under limited commitment, in which there is a country that can borrow from two blocs, friend and rival.
A “geopolitical externality” parameter captures the extent to which the country dislikes the success of the rival bloc. Suppose that the borrowing country can repay all creditors or default on all creditors but cannot discriminate among them ex post.
The borrower then has a stronger temptation to default when rivals hold a larger share of its debt, as doing so will hurt them, which is rewarded by the geopolitical externality term.
As all agents understand this incentive, they anticipate it, and the feasible lending set shifts towards allies.
As geopolitical tensions rise, the set of sustainable cross-bloc financial relationships shrinks, and risk-sharing declines.
The lesson is that geopolitical fragmentation endogenously creates financial fragmentation, which in turn reduces risk-sharing and fosters further instability.
Recognising this dynamic is a first step toward designing arrangements that preserve risk-sharing even as geopolitical tensions rise.
On June 10, Bocconi University hosted the Second Junior Workshop in Geoeconomics, organised by IEP Bocconi in collaboration with the Kiel Institute and the PERICLES Research Unit at the BAFFI Centre.
The workshop brought together early-career researchers, senior scholars and discussants for a full day of presentations and debate on the relationship between economics and geopolitics. Giovanni Rosso was among the authors of International Risk-Sharing in a Fragmented World, which received the workshop’s Best Paper Award.
IEP Bocconi does not express opinions of its own. The opinions expressed in this publication are those of the authors. Any errors or omissions are the responsibility of the authors.
