Wars and military threats disrupt sovereign bond markets
Wars rank among the largest shocks to government bond markets. A new study drawing on two centuries of data for more than 90 countries provides the most comprehensive account to date of how war—and even the mere threat of going to war—affects the sovereign bond market. The costs of wars reach well beyond the battlefield, impacting investors and government borrowing costs worldwide. The effects of military threats, which are documented for the first time, imply an asymmetry whereby they lower the bond prices of the targeted country, while the bonds of the threatening country show little reaction.
Military conflict and threats of going to war are persistent features of the world: since 1870 there has not been a single year without a war somewhere, and in more than 90 percent of years a new conflict began. Yet how they affect sovereign debt markets has remained largely unmeasured.
The new study, “Wars, Threats, and the Sovereign Bond Market” provides the first long-run global evidence on this question. The study was conducted by Jonathan Federle and Christoph Trebesch of the Kiel Institute for the World Economy, together with Robin Greenwood of Harvard Business School, Josefin Meyer of DIW Berlin, and Carmen Reinhart of Harvard Kennedy School.
To measure how wars are priced in bond markets, the authors built the External Bond Index (EXBI), a 200-year index of sovereign bonds denominated in US dollars and British pounds, based on more than 300,000 monthly price observations. It is the first long-run global index of its kind and allows us to measure the effects of war and military threats on sovereign lending conditions in unprecedented depth.
The study finds that a typical increase in the number of wars worldwide lowers creditor returns on the global sovereign bond market by about 5 percentage points, comparable to the effect of a major global recession. This falls on two groups. First, investors holding sovereign bonds—pension funds, insurers, banks, and households—suffer capital losses as bond prices drop. Second, sovereign borrowers, the governments issuing the debt, face higher borrowing costs precisely when a war may be straining their budgets. Wars alone explain about 5 percent of the variation in global bond returns in the year of the shock, and more than 10 percent over the following three years.
War sites face bond market crashes
For any individual country, becoming a war site is rare—facing combat on one's own territory happens with a probability of only about 3 percent per year. But when it happens, the consequences for sovereign debt are severe: wars fought on a country's own territory account for roughly one quarter of all bond market crashes, defined as a negative annual return in excess of 20 percent, in the historical sample. A typical war on a country's own soil lowers bond returns by almost 10 percentage points on impact and raises the probability of sovereign default by about 7 percentage points in the years that follow. These losses reflect broad-based economic turmoil rather than a single cause: after a war starts, economic output falls by around 12 percent, consumer prices rise by about 20 percent, capital is destroyed, public deficits widen, and currency and debt crises become more likely at the same time.
"From the perspective of financial markets, wars are not isolated geopolitical events—they are macro-financial multicrises," says Christoph Trebesch, Director of the Kiel Institute's Research Center International Finance and co-author of the study. "During wars, output collapses, inflation surges, public finances deteriorate, which means that several shocks hit at once.”
Not only wars, but also military threats deteriorate returns
Markets react not only to actual fighting but also to threats. Using a database of more than 10,000 diplomatic and military incidents since the early nineteenth century, the study finds that explicit threats lower the bond prices of the targeted country, while the bonds of the threatening country show little reaction. The reason is that a threat raises the probability that the targeted state—but not the aggressor—becomes a war site, and markets reprice that higher risk. Threats also tend to run from larger to smaller economies: the bigger economy in a dispute is more likely to issue the threat. In the data, the most frequent issuers of threats are Russia, the United States, the United Kingdom, China, and France; the most frequently threatened are Russia, Turkey, the United States, China, and Japan.
"This is the first systematic evidence that a country can disrupt sovereign lending to its adversaries simply by threatening force," says Jonathan Federle, researcher at the Kiel Institute and co-author of the study. "Military pressure works not only through actual fighting but also through financial markets. It shows that security and deterrence have a measurable economic value, and that the costs of intimidation fall on the threatened country—typically the weaker side—not on the one issuing the threat."
This is one of the several recent papers by the Kiel Defence Economics Initiative.
