Investments in the Shadow of War

• In Event: Economic Sanctions and Global Business

Abstract

How sensitive are countries to economic loss due to conflict? To what extent does global economic exchange deter conflict between countries? How do firms factor in the possibility of war when making their investment decisions?
Much of the previous research on this issue studies the relationship between trade and military conflicts. However, trade constitutes only a small part of the global economy. By shifting the focus to capital markets, which constitute a much larger portion of the global economy, this paper deepens our understanding of the relationship between global economic exchange and inter-state conflicts. Using a combination of a game theoretic model and empirical analysis, this paper re-examines the pacifying effect of economic ties between countries. The formal model in this paper accounts for the inherent endogeneity of investment flows to inter-state conflict. This endogeneity arises from the understanding that countries considering initiating conflict will need to account for the disruption in economic exchange with other countries at the start of hostilities, however, firms take into account the ex-ante risk of conflict when making investment decisions. By modelling this endogeneity, this paper provides a framework that more accurately captures how foreign investments affect military conflicts. The empirical analysis builds on the framework provided by the formal model. Using data on mergers and acquisitions decisions of multinational firms, the empirical analysis validates the insights generated from the formal model and presents a more efficient valuation of the deterrence effect of foreign investments.

Author

• Harshal Zalke, Princeton University