The connections that bind: Political connectivity in the face of geopolitical disruption

Abstract

While a firm can minimize its own political risk, there are idiosyncratic and country-specific risks that are more difficult to control. In particular, home country governments pursue their own foreign policies independently of business, forging international linkages with other countries in pursuit of tangible benefits. But what happens when a government forges connectivity to a country which exhibits volatility or generates geopolitical shocks? This paper examines this question by studying the response of European stock markets to the ongoing (since 2014) Russian invasion of Ukraine. Using a variety of metrics to measure political connectivity, we distinguish between anti-Russian governments and governments which are more favorable to Russia during this period, combining this connectivity data with a new database of sanctions and war-related events. Applying asymmetric GARCH, panel estimations, and event study methods, we find that the uncertainty caused by Russian aggression in Ukraine has harmed financial markets in countries such as Serbia and Hungary, countries which have willingly forged connections with Russia during this time. Consistently, our empirical results show that, by tying a country to another one via political means, politicians also have tied the fortunes of their capital markets to the success or failure of this partner.