Global economic ties continue to change in ways and tactics investors have not seen over several years. Post several years of shocks—which includes COVID-19 pandemic and Russia’s invasion of Ukraine—there are countries who are reevaluating trading partners on the basis of economic and national security concerns. Therefore, it is of utmost important to analyse and understand geopolitics and its Impact on stock markets, trade and dollar values.
Foreign direct investment flows are now being re-directed on the basis of geopolitical lines. There are countries who reevaluate heavy reliance on dollar with international transactions and reserve holdings.
Recently, CNBC reported that there have been calls which direct moving away from the U.S. dollar the purposes of trade. Several countries — ranging from Brazil to South-east Asian nations — are now focusing for trade to be carried out in several other currencies except the USD.
Why is there dominance of US dollar?
Before understanding geopolitics and its impact on stock markets, trade and dollar values, it is important to understand why USD has its own dominance.
U.S. dollar is being tagged as a king in global trade for decades. Well, there are 2 reasons for the same. Firstly, the U.S. is being categorised as world’s largest economy. Secondly, oil, which is a key commodity needed by all economies irrespective of its size, is being priced in USD.
Apart from this, there are several commodities which are being priced and traded in US dollars. The US dollar continues to dominate global forex reserves. This is despite its share in central banks’ foreign exchange reserves being dropped from over 70% in 1999, per IMF.
The US dollar made up for ~58.36% of global foreign exchange reserves in 4Q of the previous year, as per IMF’s Currency Composition of Foreign Exchange Reserves (COFER). In comparison, euro is a second (but the margin is quite wide), making up for ~20.5% of global forex reserves. Also, Chinese yuan made up for ~2.7% during same period.
Despite higher geopolitical risks, recent data exhibits that the US dollar is dominant. As per SWIFT, it makes up for more than 80% of trade finance. This is because much of commodity trade is being invoiced and settled in dollars.
The US dollar makes up for ~60% of FX reserves. This is even after gradual diversification of FX reserves away from dollar and partly in non-traditional reserve currencies. These include the Australian dollar, Canadian dollar and the like.
Geopolitics and its impact on stock markets
Geopolitics refers to broad analytical framework associated to international relations. This brings in different phenomena including political instability, tensions and military conflicts, terrorist threats, etc. which can impact regional or global economy.
In financial markets, geopolitics can impact in the form of direct capital controls or financial sanctions. Indirectly, it can be through increased uncertainty, risk premium or asset price surges.
Indian equity markets ended lower in the week gone by as a result of fall in IT stocks, expectations about likely delay in the US rate cuts, and geopolitical tensions in Middle East. For the week ended 10th May 2024, Sensex saw a fall of ~1.84%.
The decline in overall market was mainly because of Israel’s military chief’s statement. It said that there will be response to Iran’s attack. This increased probability of tensions in Middle East which impacted the market’s performance.
On the trade side, higher restrictions as a result of tensions can impact trade flows and result in supply chain problems. These restrictions can impact commodity prices and result in shortages of critical resources including oil and gas. This can impact industrial production.
For example, IMF reported that China’s share in the US imports saw a fall of 8% between 2017 and 2023. This was because of increase in trade tensions. During this period, the US share in China’s exports declined by ~4%.
Geopolitical risks can also impact the currency market. This is because these risks can lead to new policies or can bring changes to existing policies. These new regulations or changes can influence the market.
Conclusion
While geopolitics and its impact on stock markets, trade and dollar values can be huge, this risk can be avoided to a large extent. Risk identification and analysis, enhancing supply chain flexibility, leveraging technology for anticipating, etc. are some of the measures which can help.
AI and machine learning should be used for predictive analytics, providing insights in potential supply chain disruptions. Blockchain technology supports supply chain transparency. This supports businesses to efficiently monitor and track the movement of goods across borders.