Surviving the Global Financial Crisis

In our paper, Surviving the Global Financial Crisis: Foreign Ownership and Establishment Performance, forthcoming in the AEJ: Economic Policy, we examine the differential response of establishments to the recent global financial crisis with particular emphasis on the role of foreign ownership. In 2007-2008, the world economy entered the deepest financial crisis since World War II. Countries around the globe witnessed major declines in output, employment, and trade. GDP in industrial countries fell by 4.5 percent while average GDP growth in emerging economies dropped from 8.8 percent in 2007 to 0.4 percent. The unemployment rate rose to 9 percent across OECD economies, and reached double digits in a mix of industrial and developing nations. World trade volume plummeted by over 40 percent in the second half of 2008, collapsing at a rate that outpaced the fall of total output.

The severity of what has been labeled as the Global Financial Crisis led many economists to explore its macro patterns and causes. Rose and Spiegel (2010), for example, investigate the potential causes for the differential extent of the crisis across countries. Using a large country-level dataset, they do not find international trade and financial linkages and other major economic indicators to be clearly associated with incidences of the crisis. Eaton et al. (2009), Levchenko, Lewis and Tesar (2010), and Chor and Manova (2011), among others, examine the potential causes of the great trade collapse, a phenomenon that received particular attention, and find, respectively, manufacturing demand, vertical specialization, and credit conditions to play important roles.

Less explored in this debate is the pattern of micro economic responses to the crisis.  In this paper, we examine the differential performance of establishments during the global crisis with particular emphasis on the role of foreign ownership. We investigate how foreign ownership affected establishments’ resilience to the negative economic shocks using a worldwide establishment panel dataset that reports detailed operation, location, and industry information of over 12 million establishments in 2005-2008. We exploit how multinational corporation (MNC) subsidiaries around the world responded to the crisis relative to local establishments and the underlying mechanisms that led to the differential impact. This question is central to ongoing policy debates over the role of foreign direct investment (FDI) in economic growth and volatility. For many countries, such as Ireland, Slovakia, Singapore, and Malaysia, which have heavily relied on FDI as an engine of economic growth, there are increasing concerns that FDI is more volatile than domestic investments and renders countries greater economic vulnerabilities especially during economic crises.

Evaluating the role of foreign ownership during economic crises poses several challenges. First, it is difficult to disentangle the effect of foreign ownership from other establishment-level characteristics such as size and productivity and macroeconomic factors such as market demand and credit conditions. Second, why foreign ownership could lead to differential establishment performance often remains unclear. Different aspects of foreign ownership can exert sharply different, and even opposing, impact on establishment performance. For example, the ability of multinationals to shift production across countries can lead to more volatile performance while market diversification can lend stronger stability. Assessing only the average effect of foreign ownership can fail to capture these different mechanisms. Third, foreign ownership can affect establishment performance in both crisis and non-crisis periods. It is important to separate the general effect of foreign ownership from its impact on establishments’ responses to negative economic shocks.

To disentangle the effect of foreign ownership from the effects of other establishment and macroeconomic factors, we adopt in our analysis a matching technique that creates a missing counterfactual for each MNC subsidiary. The matching pairs each MNC subsidiary with a local establishment that shares similar attributes and operates in the same country and industry. Similarity is determined based on establishment-level economic characteristics that have explanatory power in explaining establishments’ foreign ownership status. Matching on the basis of characteristic similarity helps control for observable and unobservable differences between MNC subsidiaries and local establishments. Drawing the match from the same country and industry helps control for macroeconomic factors. The effect of foreign ownership is hence inferred from the divergence in the performance paths between MNC subsidiaries and their local matches.

To shed light on why foreign ownership could lead to divergent performance between MNC subsidiaries and local competitors during the Global Financial Crisis, we explore two distinct aspects of foreign ownership that have been highlighted in the theoretical literature of multinational firms.

The first aspect concerns the production linkages between MNC subsidiaries and parent firms. The existing theoretical literature on the determinants of MNC activities led by Markusen (1984) and Helpman (1984) stresses two main types of MNC subsidiaries: horizontal, which duplicate the production activities of parent firms, and vertical, which share an input-output linkage with parent firms. While horizontal subsidiaries share a substituting relationship with parent firms, the production of vertical subsidiaries complements that of parent firms. In a time of crisis, when a host country experiences a decline in demand, the two types of linkages can lead to sharply different impact. For horizontal MNC subsidiaries, the ability of MNCs to shift production back home will likely result in more volatile performance. For vertical subsidiaries, the intra-.rm demand from parent firms will help absorb the negative demand shock in the host country, leading to more resilient responses to the crisis. This stabilizing role of vertical production linkages should be particularly pronounced in host countries with large negative demand shocks. We construct a direct measure of production linkages by examining the input-output relationship between the primary products of the subsidiaries and parent firms, i.e., the input-cost share of the subsidiary’s primary product category in the parent firm’s final-good production. Subsidiaries sharing stronger vertical production linkages with the parents are expected to exhibit more resilience during the crisis.

The second aspect of foreign ownership concerns the financial linkages between MNC subsidiaries and parent .rms. An emerging strand of theoretical studies such as Antras, Desai, and Foley (2009) highlights MNCs’ internal capital markets and investment flows from parents to subsidiaries. In this analysis, we consider how MNCs’ internal capital markets lower subsidiaries’ dependence on host-country credit conditions, an advantage particularly important when host countries experience credit crunches. To examine this hypothesis, we construct a measure of financial linkages between parents and subsidiaries in each industry using the ratio of investments in subsidiaries relative to total assets. We also consider an alternative approach by constructing a measure of sectoral financial dependence and investigating how the effect of foreign ownership varies with the reliance on financial capital. According to our hypothesis, the effect of foreign ownership on establishment responses to credit crunches should be more pronounced in industries with stronger intra-firm financial linkages and greater financial dependence.

To establish the impact of foreign ownership and linkages on establishment responses to negative economic shocks, we explore the time variation of the data and separately consider the non-crisis (2005-2007) and the crisis (2007-2008) periods. This enables us to use the non-crisis period as a benchmark and compare the effect of foreign ownership during the crisis with its effect in non-crisis years. The comparison helps us identify the effects of foreign ownership that are exclusive to crises periods and the unique role of production and financial linkages in lending MNC subsidiaries greater resilience to negative demand and financial shocks.

Our paper offers new findings on the role of foreign ownership in establishments’ resilience to economic crises. We find that MNC subsidiaries responded on average better to the Global Financial Crisis than local controls with similar economic characteristics. Moreover, the advantage of foreign ownership was clearly pronounced during the crisis, but relatively muted during non-crisis years. Compared to local controls, MNC subsidiaries exhibited greater resilience to the crisis but not significantly better performance during normal economic periods.

By investigating why foreign ownership led to divergent performance during the crisis, our analysis also provides one of the first micro evidence on the role of production and financial linkages in establishment responses to economic crises. We show that establishments sharing stronger vertical production linkages with foreign parent firms exhibited more resilient performance during the crisis, especially in host countries with greater negative demand shocks. Horizontally linked establishments, in contrast, responded to the crisis less positively. Further, the role of vertical production linkages is found significant only during the crisis period. In the non-crisis period, vertical MNC subsidiaries did not perform differently than local matches while horizontal subsidiaries fared slightly better.

In examining the financial linkage hypothesis, we find that MNC subsidiaries exhibit a greater advantage over local counterfactuals in industries with stronger financial linkages between parents and subsidiaries. The effect of financial linkages is especially strong when host-country credit conditions worsened significantly and weak when home-country credit conditions declined. Similar to production linkages, financial linkages are not found to exert a significant effect on establishment performance in the non-crisis period. These results suggest that the linkages between foreign subsidiaries and parent firms play an important role in establishments’ resilience to economic crises, but not necessarily in their growth in normal economic time.

Finally, we show that the estimated effect of foreign ownership and linkages is robust to alternative empirical specifications that address issues such as the effect of domestic linkages and unobserved firm heterogeneity. When examining whether the production and financial linkages of domestically owned subsidiaries exerted a similar effect during the crisis, we find that compared to domestically owned subsidiaries, foreign owned subsidiaries exhibited a greater advantage over local counterfactuals in the crisis. Moreover, while financial linkages with domestic parents also played a stabilizing role, the effect of foreign financial linkages was significantly greater and only foreign production linkages had a significant and positive effect on establishments’ resilience to the crisis. The results are also robust when we control for unobserved MNC heterogeneity and limit the comparison to subsidiaries owned by the same parent firm. We find subsidiaries with stronger vertical production linkages to the parents to significantly outperform their peers in the same MNC.

Our findings offer important policy implications on the role of FDI during economic crises. Our analysis suggests that FDI exerts a significant but complex effect on economic responses to the crises. The effect is highly contingent on the type and the intensity of linkages established between parent and host countries. Our results indicate that while horizontal MNC activities might be associated with greater economic volatility, vertical production and financial linkages could potentially lessen the impact of the crisis in host countries.

The full paper is available for download here.