Global integration can be both beneficial and harmful for firms, according to research by Everett Grant and Julieta Yung, to be presented at the Royal Economic Society”s annual conference at the University of Sussex in Brighton in March 2018. Their study finds that:
• On average, more connected firms are 3.6% less likely to fall into distress by experiencing a sharp drop in their equity returns, profits or revenue.
• They are also more likely to exhibit improved growth: 1.2% higher equity prices, 4% higher profits, and 1.7% higher revenue and return on equity.
• But global integration can also be a negative: firms tend to be more susceptible to system-wide shocks during periods when neighbouring firms are also in distress – the phenomenon of ”contagion”.
The authors conclude that while contagion can spread extremely rapidly and widely with greater global firm integration – and high levels of connectedness can be a red flag – policymakers and investors should not disregard the benefits of a more integrated network, forming the double-edged sword of greater global integration.
How are firms connected?
The exact level of integration between two firms is difficult to quantify, as firms are often linked simultaneously across many dimensions that cannot be easily measured. Investors, however, closely monitor companies that trade in the market, such that their equity prices reflect all available information about them.
For example, if one firm outsources work to another, then a shock negatively affecting the client firm will be passed on to the service provider and be reflected by declines in the equity prices of both firms. Alternatively, two firms reliant on petroleum products would both be negatively affected by an oil market common shock reducing global output.
The co-movements of firms” equity returns can therefore reflect valuable information about the extent to which firms are connected with one another, both directly and via exposure to common shocks.
Measuring firm connections using machine learning
The problem of estimating the connections between hundreds or thousands of firms” equity prices is a challenging one. To overcome this, methods from machine learning can be employed to identify simultaneously the set of connections that form the inter-firm network.
Further, other tools from machine learning can be used to visualise the network and observe what types of firms are closely linked to each other and how these linkages have changed over time.
Several empirical features characterise the global inter-firm network: both industry and locality play important roles in connectedness between firms; multinational firms across countries have become more connected over time; and the United States and the financial sector are at the centre of the network.
Robustness and fragility
On average, global integration helps to mitigate idiosyncratic as well as system-wide shocks, increasing companies” growth prospects and reducing the incidence of firm distress events. In other words, global integration generates ”robustness” in the system.
At the same time, when a shock occurs placing a firm in distress, firms that are more connected to it are likely to fare worse as they are apt to have exposure to the same underlying shocks.
Additionally, firms tend to be more susceptible to system-wide shocks during periods when neighbouring firms are also in distress. Therefore, global integration also generates ”fragility” in the system, consistent with the idea of integration being a double-edged sword and generating a system that is ”robust-yet-fragile”.
Understanding how firms are connected across industries and countries can help in measuring systemic risk and developing strategies to prevent the widespread transmission of shocks. As recent history has emphasised the significance of international developments and contagion, policy-makers, investors and regulators are in need of methods to identify and understand these inter-firm connections.
This work concludes that while contagion can spread extremely rapidly and widely with greater global firm integration – and high levels of connectedness can be a red flag – policy-makers and investors should not disregard the benefits of a more integrated network, forming the double-edged sword of greater global integration.
Federal Reserve Bank of Dallas | EGrant.Econ@gmail.com
Bates College | JYung@Bates.edu