Geopolitical risk and U.S. foreign portfolio investment: A tale of advanced and emerging markets

Abstract

We study how U.S. portfolio investors react to the geopolitical risk in destination countries. First, we uncover significant heterogeneity between advanced and emerging market destinations: U.S. investment in foreign bonds and equities decreases only in response to heightened geopolitical risk in emerging markets, not in advanced markets. Second, we identify poor institutional quality and, to a lesser extent, closed capital markets in emerging market economies as the primary driver behind the larger sensitivity of portfolio investment to geopolitical risk. Third, we find a contagion effect that U.S. portfolio investment declines significantly in response to the heightened geopolitical risk in nearby countries even after controlling for the risk in the destination country. This contagion effect is confined to emerging markets, further highlighting the difference between advanced and emerging markets.