How Geopolitical Risk Impacts Forex Markets

Major geopolitical tensions and conflicts in the world however impact the financial markets, making financial planning more complex. Bianca Botes, Director at foreign exchange and treasury experts Citadel Global, explains how geopolitical factors can affect foreign exchange (forex) trading specifically. 

Currency fluctuations 

By definition, the forex market is a market where different currencies are bought and sold. The biggest and most highly traded currency is the United States (US) dollar; however, the US is currently embroiled in escalating tensions with economic rival China. Tensions are also fuelled by the on-going Russia-Ukraine war, as well as US warnings to China of serious consequences if it provides arms to Russia. China in turn is also experiencing tension with Taiwan, Hong Kong, the Philippines, and South Korea. 

Each time regional tensions flare, it causes more currency fluctuations that ripple through the global currency landscape. While South Africa’s government maintains its impartial stance on the Russia-Ukraine war; the West is now considering South Africa to be too friendly with Russia which is weighing on the rand. This was escalated by government’s apprehension to arrest President Vladimir Putin should he arrive in South Africa in accordance with the International Criminal Court’s arrest warrant. 

Financial system fragmentation 

The International Monetary Fund (IMF) recently warned that “rising geopolitical tensions among major economies have intensified concerns about global economic and financial fragmentation”.  The foreign policy shifts that happen due to geopolitical tensions could have substantial long-term impacts on the cross-border allocation of capital and the direction of capital flows, international payment systems, asset prices, supply chains, financial markets, and trade relations. Volatility in the longer term reduces international risk diversification for adverse domestic and external shocks. 

Emerging markets pull short straw

In the financial market context, geopolitical tension leads to uncertainty, and anytime there is increased uncertainty, risk appetite deteriorates and risk assets such as emerging market assets, come under strain. An increase in geopolitical tensions could cause a sudden reversal of cross-border capital flows, with the effect being that emerging market and developing economies experience greater forex upheavals than advanced economies. All these tensions pose volatility risks for emerging markets’ currency markets. 

Banking risks heightened 

In addition, global political tensions could pose macro-financial stability risks by increasing banks’ funding costs, reducing their profitability, and lowering their provision of credit to the private sector. These impacts are likely to be disproportionately larger for banks with lower capitalisation ratios. One of the side-effects of this situation is that the financial markets have lower liquidity and is therefore less able to trade in forex when it needs to. 

The global ecosystem

In an increasingly globalised world, the interconnectedness of countries has become more and more pronounced, with fallouts in one country or region leading to fallouts in the countries with which they share trade ties and alliances. This ripple effect makes it very hard to navigate the volatile forex environment, placing increased importance on getting professional forex advice and risk management.