Globalization and Financial Instability

The global financial system entrenches vulnerability and is structurally pro-cyclical. Climate change is amplifying those structural biases. A new ECB analysis on climate shocks & sovereign bond yields puts these dynamics into stark relief: https://lnkd.in/grtNu6CK But first, a step back. The global financial system is not neutral. - Income level shapes perceived risk; EMDEs are perceived as high risk. - financial architecture & ratings amplify that bias, rather than addressing vulnerability through counter-cyclical support & credible backstops Wealthy countries borrow in their own currencies. They have deep domestic capital markets that absorb shocks. Their central banks provide liquidity. They can sustain high debt w/out triggering panic. Poor countries must borrow in FX, exposing them to currency risk. Sovereign ratings don't consider pro-growth effects of long-term, concessional borrowing for public investment; all borrowing contributes to debt metrics. High borrowing costs for EMDEs constrain investment → constrained investment slows growth & weakens resilience → reinforces perceptions of risk → raises borrowing costs further. The cycle feeds itself. That is the core argument of our paper on Lowering Cost of Capital in EMDEs: https://lnkd.in/ghXsizrE Abundant global capital is least accessible/affordable to the countries that most need it. Climate now layers onto this structural bias. → When cost of capital is high, even compelling investments in clean energy, e-mobility and resilient infrastructure are not financeable. (a project that works at 3% financing may not at 9%). → The ECB analysis shows that EMDEs that cannot finance transitions then face higher spreads when decarbonization lags. → Limited fiscal space also means EMDEs underinvest in resilience. → The ECB analysis shows that when shocks occur, vulnerability is penalized again with higher yields. → Higher yields further constrain investment. Advanced economies face far more muted effects. In addition to the stabilization mechanisms they can access, debt tolerance is self-reinforcing. Climate change is amplifying the structural, pro cyclical inequality embedded in global finance. The answer is not for fiscally-constrained countries to borrow less. That deepens the trap. The imperative is to reverse the cycle: → Ensure EMDEs have access to long maturity, low cost finance for productive public investment. → Reform debt sustainability frameworks & sovereign ratings to recognize pro-growth effects of investment in infrastructure & resilience. → Scale guarantees/risk-sharing mechanisms so risks are distributed to those able to absorb them. → Extend liquidity backstops to EMDEs to prevent post-shock spirals. Correcting these structural biases would not only support sustainable development in EMDEs. It would accelerate the global transition, increase resilience, and strengthen market stability in the fastest growing economies in the world.

In 2005, when Thomas Friedman proclaimed “the world is flat,” globalisation appeared irreversible. The fall of the Berlin Wall, China’s entry into the WTO, the rise of the internet and the spread of global supply chains compressed distance and time. The assumption was that economic integration would lead to rising prosperity and a shared stake in stability for everyone. Two decades later, the world looks anything but flat. The 2008 global financial crisis was the first fracture. It exposed how deeply interconnected the system was, but also how unevenly its risks and rewards were distributed. Inequality widened within countries even as millions were lifted out of poverty globally. Then came geopolitics. Supply chains that had been optimised for cost and efficiency began to be seen as vulnerabilities. The pandemic delivered the shock therapy as Governments discovered how dependent they were on distant factories for essential goods. During the era of “hyper-globalisation” (1990–2008), global trade grew almost twice as fast as world GDP. After the global financial crisis, trade still grows, but no longer faster than the world economy. Capital flows tell a similar story. Foreign direct investment peaked before 2008 at over 5% of global GDP and has since fallen to roughly half that level, while becoming more volatile and more nuanced. Investment is more regional, more strategic and less frictionless. Supply chains, once optimised ruthlessly for cost, are now being redesigned for resilience. This shift from efficiency to redundancy leads to structurally higher costs and more inflation volatility. If globalisation delivered such clear economic benefits, what caused its slowdown? The core reason is not economic failure, but political. Globalisation grew global output, but it did not distribute gains evenly within countries. In many economies, wages stagnated even as profits and asset prices rose. Communities lost jobs faster than they gained new ones. This domestic backlash then collided with geopolitics. The pandemic and the war in Ukraine reinforced the lesson: efficiency without control can be dangerous. The deeper issue was institutional. Capital moved freely but safety nets remained national. When shocks hit, citizens turned to governments, not global systems, for protection. The implications for the global economy are profound. Growth is becoming more fragmented, less synchronised. Inflation is likely more volatile. The world economy looks less like a single engine and more like loosely connected regional systems. What lies ahead is not de-globalisation, but re-globalisation with constraints. A world of blocs, buffers and “trusted” networks. Less flat, more uneven. Less efficient, more resilient. The age of frictionless globalisation may be over, but interdependence is not. The challenge now is managing it without letting fragmentation become the new systemic risk.

Powerful cross-border flows could overwhelm domestic valuation arguments, dilute monetary policy transmission, and often wreak havoc on EM capital accounts. It was this trend, in fact, that led me to develop a global risk appetite framework in 1998 to guide my thematic investment process. Using this framework, our Fund was able to successfully predict many market trends where economists and Authorities were struggling to explain long-term deviations from fair-value in currency markets. Rising risk appetite in the major markets (primarily the US), driven by favourable domestic financial conditions, would lead to increased opportunistic allocations to international assets, taking on both the asset class and currency risk. Exposures to int’l in the 90s were low, and diversification was part of the incentive, so local valuations in overseas markets (including currency) were less of a concern. No where was this more true than in Asia where I was based from 1985-2003. This trend eventually became synonymous with globalisation. Globalisation in financial markets was always an early and constant frontier-pushing trend. What started out as cyclical swings in risk appetite and bouts of synchronised global growth driving opportunistic allocations eventually became structural. This was most evident in the steady march higher of Int’l weights in popular benchmarks. The market traded each annual MSCI or S&P Int’l index rebalancing event as a catalyst for new flows into the peripheral growth countries. Similarly, as domestic regulators raised Int’l asset allocation ceilings for pension funds, the market positioned for new outflows. These structural outflows were further propelled to new highs by the rise of passive funds management. Forecasting cross-border capital flows became part cyclical/opportunistic, part structural, but while globalisation was in an upswing, the direction of capital outflows - and the benchmarks used to attribute them - were pointing in the same direction. With this fundamental fact pretty well understood by the market now, most should agree that ‘peak globalisation’ must mark a point where this three-decade trend in structural capital market outflow plateaus and eventually rolls over. The question is, have we arrived at that point?

Trade wars used to be something you read about. In 2026, they're something you budget for. The US-India deal in February dropped tariffs from 25% to 18%. Goldman Sachs upgraded India's GDP forecast to 6.9%. Markets rallied 2.5% in a day. Sounds like good news. But zoom out. The World Economic Forum's latest survey of corporate economists named trade disruption the top force driving global uncertainty this year. Some Indian exporters still face total tariff loads up to 50% on specific goods. And deals can reverse as fast as they're announced. If your income, investments, or career sit in a tariff-exposed sector, geopolitics belongs in your financial plan. Right now. What I'm seeing across India: - People in IT services, textiles, and pharma exports are asking if their job security and portfolio should be in the same sector. Good question. Usually the answer is no. - People wondering whether to go to cash. Data says that's almost always wrong. Investors who went to cash during the 2025 tariff sell-off missed the full recovery. - People aren't checking currency exposure. If you hold investments, earn income, or carry debt in multiple currencies, you've got a risk most people don't even name. A few things worth doing now: → Build a bigger cash buffer. 6 months minimum. 12 if you want peace of mind. Keeps you from selling long-term positions at bad prices.  → Separate employment risk from investment risk. If your industry is tariff-exposed, your portfolio shouldn't be concentrated there too.  → Don't go to cash entirely. Full cash feels safe but carries real compounding cost over time. Stay diversified with a buffer. PROTECT in SOAR UP is built for this. Financial flexibility means your plan absorbs shocks without falling apart. Has trade uncertainty changed your financial plan? What did you adjust? Share below. ♻ Repost so others see this too. Follow me for more posts on financial flexibility.

-Japanese yields are rising & that’s more than a local rates story; they’re a direct line to one of the deepest sources of global leverage: the yen carry trade. -As JGB yields climb, funding costs rise & the economics of borrowing yen to lever into global bonds, equities, and relative-value trades begin to unwind. -That matters because hedge funds have built significant leveraged exposures using yen-funded positions, often with Japanese collateral. -The Bank of Japan’s Financial System Report highlights the rapid buildup of global hedge fund leverage using Japanese collateral. -Fixed-income arbitrage funds have massively expanded leveraged bond positions across the U.S., Europe, & Japan, making the system highly sensitive to sharp yield moves. -Repo markets are now the core funding engine, with hedge funds accounting for nearly 50% of U.S. repo activity (a record high) borrowing trillions against Treasuries and JGBs. -JGBs are increasingly recycled as global collateral, with Cayman-based funds and offshore hubs now major players in JGB trading & repo chains. -The BoJ warns that while Japanese banks’ direct exposure to hedge funds is limited, indirect exposure via collateral chains is rising, turning JGBs into a channel for global volatility as yields climb. -Similarly, the Federal Reserve’s Financial Stability Report echoes similar concerns, noting that hedge fund leverage is near historical highs across Treasury, derivatives, and equity strategies, with insurers’ leverage also elevated. Sources: https://lnkd.in/gwSm665p & https://lnkd.in/gieycGh9)

In a new OpEd for MarketWatch I discuss the risks associated with economic and financial #fragmentation. Fragmentation arising from #geopoliticaltensions reduces scope for international #portfoliodiversification and can exacerbate #financialmarket volatility, because foreign governments may override market signals and take steps to advance their own evolving geopolitical strategy. This is particularly relevant at a time when #equity portfolios are highly concentrated. U.S. equities account for about 65% of global equity indexes, with the U.S. Magnificent Seven alone making up more 20% of these same global indexes. The old order of #globalization is dying. The new order of fragmented trading blocs is rising. Within this new order, market signals will be at work alongside other considerations, such as #nationalsecurity, #supplychain priorities and geopolitical objectives. Investors should pay attention. The rules of this order are more opaque and government actions are less reliable and more intrusive, limiting the benefits of #diversification and potentially weakening confidence in the U.S. as a safe destination for foreign savings. The U.S. retains a unique role in the global economic and financial order due to its economic size, its military might, the depth and liquidity of its #financialmarkets and the lack of obvious alternatives for investors. This advantage may not last forever. https://lnkd.in/ep9P7bZi

Capital allocation is no longer neutral. It is increasingly geopolitical. The prevailing assumption is that capital flows toward the highest risk-adjusted return, guided by market efficiency and diversification. Geography is treated as a secondary factor. Politics is seen as noise around fundamentals. That assumption weakens in a fragmented global system. Sanctions, trade restrictions, capital controls, and industrial policy are now shaping where capital can move, not just where it wants to move. Strategic sectors attract directed investment. Cross-border flows are filtered through national interest. The deeper mechanics are structural. Regulatory regimes define permissible exposure. Currency stability influences allocation preference. Supply chain security redirects long-term investment. State-backed capital competes with private capital on non-financial terms. These forces alter incentives. Capital is not only priced by return. It is constrained by access, alignment, and political risk. Decisions that once depended on valuation now depend on jurisdiction and policy direction. The second-order effect is segmentation. Global capital markets become less integrated. Pools of capital form around regulatory blocs. Liquidity concentrates within aligned systems and withdraws from contested ones. For boards and investment committees, the implication is direct. The question is not only where returns are highest. It is where capital remains deployable, protected, and recoverable when geopolitical conditions change.

At the heart of the global monetary and financial system sits the foreign exchange market (FX Market)- a highly liquid market which processes $9.8 trillion worth of transactions every single day. The foreign exchange market facilitates trade and the movement of money globally - it has grown 5x since the 1990s. Central to this market are a handful of currencies anchored by the US dollar (USD). The USD has become increasingly dominant since the end of Bretton Woods as it supplanted gold. Currently, over 60% of the world’s economies anchor their currencies to the USD in one form or another and 89% of all global transactions are conducted in USD. Yet, the FX Market seems increasingly susceptible to policy uncertainty and macroeconomic shifts. Last week, the International Monetary Fund (IMF) warned that shifts in policy that elevate volatility and uncertainty are likely to adversely impact the FX Market. Disruptions in the FX Market could then bleed into other assets such as equities and bonds with widening currency bid-asks, higher FX volatility, more illiquidity and increased funding and hedging costs. These shifts can have negative repercussions on global yields and risk premia as countries and corporates have to manage their currency exposures.   Historically, increased uncertainty was good for the USD. Since 2002 at least, any heightened volatility or increases in perceived or real risks has meant USD appreciation. In 2025, that long established pattern broke. In April, for example, demand for the USD in the spot market was less than it was during previous cycles of higher VIX. The USD, instead, depreciated by 6.5% against the Euro and on Oct 10, the DXY was lower on news of further trade escalations. In contrast, when tariffs were imposed in 2018 and 2019, the USD rallied by 10% in ‘18 and 5% in ‘19. A USD trending lower may make US companies less attractive to non-US investors as their returns in home currencies are lower (think of a non-US country with a depreciating currency and its impact on returns in USD). Less investment by foreign investors effectively means less demand for USD potentially creating a self-enforcing negative cycle for the USD and a virtuous cycle for other currencies. In addition, if the USD is no longer an automatic “buy” at times of stress, it will become less attractive and further lowering demand. Lower USD relative to other currencies means higher inflation as import prices increase, elevated yields for corporates and the US government as well as lower demand for US assets by non-US investors (as they worry about the exchange differential). None of these are good for US assets or US Markets. Instead, inflation protection strategies, hard assets (that don’t melt down on a whim) and non-US assets may thus become increasingly more attractive for global investors looking to mitigate against the consequences of this paradigm shift. PS: Not AI content. Not investment advice.

🏦 𝗛𝗶𝗴𝗵 𝗘𝗰𝗼𝗻𝗼𝗺𝗶𝗰 𝗨𝗻𝗰𝗲𝗿𝘁𝗮𝗶𝗻𝘁𝘆 𝗠𝗮𝘆 𝗧𝗵𝗿𝗲𝗮𝘁𝗲𝗻 𝗚𝗹𝗼𝗯𝗮𝗹 𝗙𝗶𝗻𝗮𝗻𝗰𝗶𝗮𝗹 𝗦𝘁𝗮𝗯𝗶𝗹𝗶𝘁𝘆 Global economic uncertainty has been amplified by a confluence of factors, including the COVID-19 pandemic, inflation shocks, escalating geopolitical tensions, rapid technological advancements, and climate-related disasters. According to the recent International Monetary Fund report, high macroeconomic uncertainty can significantly raise downside risks for economic and financial stability, and the relationship may be stronger when macrofinancial vulnerabilities are elevated, or financial market volatility is low. Uncertainty is not as easily measured as traditional indicators like growth or inflation, but economists have built some reliable proxies. ►►To reduce domestic macroeconomic uncertainty and its adverse implications for macrofinancial stability, policymakers are recommended to build credible policy frameworks and improved communication strategies. They are also advised to build resilience against macrofinancial vulnerabilities, particularly when macroeconomic uncertainty is high. The following 𝗽𝗼𝗹𝗶𝗰𝘆 𝗿𝗲𝗰𝗼𝗺𝗺𝗲𝗻𝗱𝗮𝘁𝗶𝗼𝗻𝘀 are highlighted in the report to mitigate the risk:  ►Reducing domestic macroeconomic uncertainty by strengthening the credibility and transparency of frameworks for monetary, fiscal, and financial sector policies and through effective communication strategies. ►Implementing adequate fiscal and macroprudential policies to contain macrofinancial vulnerabilities and build resilience against adverse shocks, particularly when macroeconomic uncertainty is high. ►Building adequate international reserve buffers and allowing exchange rate flexibility to help cushion the adverse spillover effects of an increase in foreign macroeconomic uncertainty. ►Devoting resources to quantifying, managing, and mitigating the risks from rising geopolitical uncertainty on macrofinancial stability. Read more below. Chapter authors: Rafael Barbosa, Yuhua Cai, Mario Catalán (co-lead), Andrea Deghi (co-lead), Li Lin, Tatsushi Okuda, Mustafa Yasin Yenice, Aleksandr Zotov, under the guidance of Mahvash Qureshi, Ian Dew-Becker and Stefano Giglio as external advisors.