Research: When Geopolitical Risk Rises, Innovation Stalls
The impact of geopolitical conflict on global trade and security is clear. But how do rising geopolitical risk levels affect corporate innovation? The authors cross-referenced data from 4,625 U.S. companies over 32 years with a global index of geopolitical risk to quantify the link between geopolitics and innovation. At a high level, their analysis suggests that geopolitical risk has a substantial stifling effect on private sector innovation, in particular for companies with substantial exposure to foreign markets, and that that negative impact can persist for three to five years after the initial conflict. In light of these findings, the authors offer strategies to help companies minimize the impact of geopolitical risk on their own innovation, but argue that ultimately, the only way to address the underlying issue is for political and business leaders (alongside other key players, such as lawmakers and media platforms) to work together to reduce global tensions and build a more peaceful — and innovative — future.
Geopolitical risk — that is, the wide array of risks associated with any sort of conflict or tension between states — has a clear impact on global trade, security, and political relations. But how does it affect innovation in the private sector?
To explore this question, we collected data from 4,625 public U.S. companies between 1985 and 2017. We used three primary metrics to measure these companies’ levels of technological innovation in a given year:
- The number of patents the company filed
- The financial value of patents granted to the company (as measured by changes in the company’s stock price following the news of a patent grant)
- The scientific value of patents granted to the company (as measured by the number of times the patent is cited by other patent applications)
We then cross-referenced this innovation data with a monthly index of geopolitical risk (GPR) published by the U.S. Federal Reserve, which is based on a large-scale analysis of news articles from 11 top global newspapers and includes events such as the U.S. bombing of Libya in 1985, conflicts in Iraq, and the 2016 terrorist attacks in Paris. This enabled us to develop a statistical model of the relationship between GPR and corporate innovation, revealing five key findings:
1. Rising geopolitical risk stifles innovation.
We began our analysis by simply comparing GPR levels with the three innovation metrics described above. We found that on average, a 1% increase in GPR reduces the number of patents a company files the following year by 0.18%, reduces the financial value of the patents granted to the company by 0.24%, and reduces the scientific value of the granted patents by 0.08%. Collectively, these numbers suggest that rising geopolitical risk substantially stifles technological innovation among U.S. companies.
Next, we took a deeper dive into exactly what kinds of patents the companies in our dataset were filing. We found that as GPR rises, patents tend to focus less on new, rapidly evolving technologies (the hallmark of breakthrough — rather than incremental — innovation) and drew on fewer different technological fields. In other words, companies became more risk averse and less likely to pursue multidisciplinary, highly impactful innovation.
These findings are consistent with a secondary analysis we conducted, in which we leveraged a large dataset of firms’ public disclosures to examine the impact of GPR on the stages of development of companies’ entire product portfolios. We found that in years with higher GPR, a smaller proportion of companies’ products were in the early stages of development, suggesting that geopolitical risk leads companies to launch fewer new, innovative product development projects.
2. Threats can be more harmful than actions.
We were also interested in distinguishing between geopolitical threats and geopolitical acts. Interestingly, we found that on average, threats have a greater impact on innovation than acts: The average number of patents filed by U.S. companies fell more than three times more in response to an increase in geopolitical threats than it did in response to an increase in geopolitical acts. (Average financial and scientific values of granted patents followed similar trends.) This is likely because threats of action are associated with unrealized risk, while the acts themselves are a form of realized risk, meaning less uncertainty and thus more motivation to take technological risks and innovate. This aligns with intuition — fear of the unknown is often worse than fear of the known.
To be sure, while uncertainty is an important factor in driving appetites for innovation, actions borne of geopolitical conflict can also obviously be highly detrimental in and of themselves. But our research illustrates how in many cases, the threat may actually be more harmful than the action.
3. Geopolitical risk has a greater impact on companies with more foreign customers.
In the next part of our analysis, we used the Compustat database of S&P companies and their customers to better understand how a company’s target market influences the extent to which they are impacted by rising GPR. We looked at two metrics to measure companies’ exposure to foreign markets: the proportion of a company’s major customers that were foreign (versus domestic), and the proportion of a company’s revenue that came from those foreign customers.
We found that both measures of foreign market exposure correlated with a greater negative impact of GPR on innovation, with 1% increases in the foreign proportion of a company’s customers and revenue corresponding to 0.63% and 0.78% decreases respectively in the average number of patents filed. This suggests that companies who sell to customers in foreign countries likely experience greater uncertainty and will thus be more risk-averse in times of higher geopolitical risk.
4. Declines in innovation are largely driven by turnover.
Clearly, the uncertainty associated with geopolitical risk leads to less investment into private-sector innovation. But what are the underlying mechanisms driving this shift? There are no doubt many factors at play, but we identified two important ones: We found that when GPR increases, companies’ investment in R&D falls, while turnover among the inventors and scientists responsible for the patents that companies file rises.
Both of these factors negatively impact companies’ overall innovation levels, although human capital plays a much larger role than R&D investment: The drop in R&D investment was responsible for about 2% of the decrease in the number of patents filed, while the drop in human capital explained 17% of this effect — making it almost 10 times more impactful. This suggests that the decrease in innovation following a rise in GPR may be driven less by intentional managerial policies (i.e., discretionary spending on R&D), and more by factors outside managers’ direct control (i.e., employees choosing or being forced to leave their jobs).
5. The impact of geopolitical risk on innovation is long lasting.
Finally, in the last part of our analysis, we asked: How long do these adverse effects of GPR persist? We found that the negative impact of geopolitical risk on innovation typically persists for three to five years, on average reaching its peak a full two years after the initial rise in GPR. Thus, while a conflict may be short-lived, its repercussions are likely to be felt for years to come.
Of course, it is important to note that all our findings are averages. Our research also highlighted how individual companies could outperform (or underperform) depending on their individual strategic choices. For example, follow-up analyses of advertising activity from the Compustat database as well as lobbying activity from the LobbyView database suggest that when GPR rises, companies that pursue more advertising or lobbying initiatives tend to take a bigger hit in terms of innovation. This may be because advertising implies greater focus on appropriating value from existing products than on creating new ones, while lobbying may make geopolitical issues more salient for managers, thus reducing their risk tolerance.
But at a high level, our findings illustrate how individual business and global politics are tightly intertwined. While the data implies certain steps companies can take to reduce the impact of geopolitics on their own levels of innovation — avoiding an excessive focus on foreign markets, investing in retention, and potentially limiting advertising and lobbying activities — our analysis ultimately demonstrates that rising geopolitical risk is likely to have a substantial stifling effect on innovation across the board. And the only way to address this underlying issue is for political and business leaders (alongside other key players, such as lawmakers and media platforms) to work together to reduce global tensions and build a more peaceful — and innovative — future.