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The Harvard University Management Magazine has been published for a century and gathers articles based on research and data. Its authors include the best international management and business experts in a variety of fields, including leadership, negotiation, strategy, marketing, finance and operations. Harvard Business Review articles are translated and published in Globes three times a week: on Mondays, Wednesdays and Thursdays (G magazine).
About the authors
Viuk Estuanesh is Professor of Marketing at Indiana University’s Kelly School of Business, Wesley Deng is Professor of Finance at the University of New South Wales Business School, Adnan Habib is a PhD student in Finance at the University of Tasmania’s School of Economics and Business.
Geopolitical risk—the wide variety of risks associated with conflict or tension between countries—has a clear impact on global trade and political relations. But how does this affect innovation in the private sector?
To investigate this question, we collected data from 4,625 public companies in the US between 1985 and 2017. We used three main indicators to measure the levels of technological innovation of these companies in a given year: the number of patents the company filed; the monetary value of patents granted to the company (as which is measured by changes in the company’s stock price following the publication of the grant of the patent) and the scientific value of patents granted to the company (as measured by the number of times the patent was cited in other patent applications).
We then cross-referenced this innovation data with a monthly index of geopolitical risk (GPR) published by the US Federal Reserve, based on a large-scale analysis of news stories from 11 leading global newspapers, including events such as the US bombing of Libya in -1985, the war in Iraq and the terrorist attacks in 2015 in Paris. This is how we developed a statistical model of the relationship between GPR and organizational innovation, which revealed five key findings:
1. Geopolitical risk stifles innovation.
We found that, on average, a 1% increase in GPR reduces the number of patents a company registers in the following year by 0.18%, reduces the monetary value of patents granted to a company by 0.24%, and reduces the scientific value of patents granted by 0.08%. Next, we looked at what types of patents the companies in our dataset filed. We found that as GPR increased, patents tended to focus less on rapidly developing new technologies (the hallmark of breakthrough innovation) and drew on fewer different technology domains. In other words, companies became more risk-averse and less inclined to pursue multidisciplinary innovation.
We also found that in years with a higher GPR, a smaller proportion of products were in early development stages, suggesting that geopolitical risk leads firms to launch fewer product development projects.
2. Threats can be more damaging than actions.
We found that, on average, the effect of threats is even greater than actions: the average number of patents filed by US companies dropped more than three times in response to an increase in geopolitical threats, than in response to an increase in geopolitical events themselves. This is likely because threats are associated with unrealized risk, while the actions themselves are a form of realized risk, meaning less uncertainty. This aligns with intuition – the fear of the unknown is often worse than the fear of the known.
3. Geopolitical risk has a greater impact on companies that work with the international market.
In the next part of our analysis, we used the Compustat database of S&P 500 companies and their customers. To better understand how a company’s target market affects the strength of the GPR increase effect, we tested two criteria to measure companies’ exposure to international markets: the proportion of the company’s main customers that were foreign (versus domestic), and the proportion of the company’s revenue that came from those foreign customers.
We found that the two criteria of exposure to a foreign market correlate to a greater negative effect of GPR on innovation, with a 1% increase in the proportion of the company’s foreign customers and revenues corresponding to a decrease of 0.63% and 0.78% respectively in the average number of patents filed. This suggests that firms that sell to customers in foreign countries likely experience greater uncertainty and are therefore more risk averse in times of higher geopolitical risk.
4. Damage to human capital and R&D investments.
It is clear that the uncertainty associated with geopolitical risk leads to less investment in innovation in the private sector. But what are the underlying mechanisms driving this change? We found that when the GPR increases, investment in R&D decreases, while turnover among the inventors and scientists responsible for the patents that firms file increases.
Both of these factors hurt companies’ overall innovation levels, even though human capital plays a much larger role than R&D investment: the decline in R&D investment accounts for about 2% of the decline in the number of patents filed, while the decline in human capital explains 17% of this effect – making it almost 10 times worse. This suggests that the decline may be driven less by intentional management policies and more by factors outside of managers’ direct control (ie, employees choosing or being forced to leave their jobs, for example).
5. These effects are long lasting.
In the last part of our analysis we asked: How long do these negative effects last? The answer was usually three to five years, and on average the peak is reached two years after the initial increase in GPR. Thus, while a conflict may be short-lived, its consequences are likely to be felt for years.
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It is important to note that all our findings are averages. The study also highlighted how individual companies can perform better (or less) depending on their strategic choices. For example, tracking analyzes of advertising and lobbying activity indicate that as GPR increases, companies that engage in more advertising or lobbying initiatives tend to take a bigger hit in terms of innovation. This may be because advertising implies a greater focus on creating value from existing products, than on creating new products, while lobbying may make geopolitical issues more salient to managers, therefore reducing their risk tolerance.
But at a high level, our analysis demonstrates that an increase in geopolitical risk is likely to have a significant impact that stifles innovation across the board. The only way to address the problem is for political and business leaders (alongside other key players, such as legislators and media platforms) to work together to build a better – and more innovative – future.
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