A Model of Geoeconomic Fragmentation

With the rise in geopolitical tensions, we have seen a major redrawing of the map of capital flows. In particular, China’s external assets have been increasingly directed away from the United States (and other Western countries) towards countries that are more aligned with Chinese foreign policy/geopolitics (for example, Russia and Turkey). In this project, my co-author and I plan to lay out a theoretical model of borrowing and default, in which geopolitical alignments can affect both the incentives to repay debts and the allocation of capital across countries.

The purpose of our model is to identify the channels through which heightened geopolitical tensions can create more fragmented capital flows. The main mechanism is the following. Imagine a borrowing country going through bad times (e.g., low growth) so that it is facing substantial default risk. From an ex-post sense, this country would prefer to default on countries (previous lenders) that are geopolitical "rivals", other things equal. So, from an ex-ante perspective, the borrowing country has the incentive to borrow more from “friendly” countries (i.e., those with whom it is more politically aligned) to stop itself from defaulting and in that way face better interest rates, to begin with.