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New research reveals unexpected benefit of tariffs—managers make better investment decisions

New research from the University of Bath has identified an unexpected side-effect of the imposition of trade tariffs—they focus cash-strapped managers' minds on efficiency and improve their investment decisions.

"Tariffs and trade shocks are overwhelmingly bad for companies, trade, the consumer and the global economy—but our research shows there is one positive aspect—they can influence managerial investment decision-making for the better," said Dr. Hanwen Sun, Associate Professor in Finance at the university's School of Management.

The research team from the University of Bath and Jinan University in Guangzhou, China examined the investment efficiency of more than 2,000 firms in China following the imposition of trade sanctions such as tariffs and anti-dumping measures, known as 'trade defense instruments' (TDIs). The study noted more than 1,300 TDIs were imposed on China between 2003 and 2016.

"It seems counter-intuitive—that there could be an upside. There is, after all, a wealth of evidence to suggest TDIs are very costly, harming company profits and the wealth of nations. But what we found is that managers who found themselves operating in a suddenly hostile environment responded by improving efficiency, chiefly through making more considered decisions about where to invest for the future," Professor Wenjing Li from Jinan University said.

in the Journal of Corporate Finance, the study "Trade shocks and investment efficiency" focused on free cash flow and the effect of it being constrained by tariffs and sanctions. Dr. Sun said they found that investment efficiency improved in around two years after TDIs were imposed.

"Investment efficiency is related to free cash flow. If cash is abundant, it can lead to over-investment or ill-considered investment, or even empire building by ambitious managers who may not be operating in the best interests of a company.

"When that manager is confronted suddenly by tariffs or sanctions that put a large question mark over free cashflow, our research suggests they will rein in their ambitions and consider more carefully where they are putting their money for the future," Dr. Sun said.

The researchers discovered that the effect was particularly pronounced for firms subjected to higher penalty tax rates and for those producing higher-value goods targeted by TDIs.

Additionally, TDIs have the effect of intensifying competition in domestic markets as doors to overseas markets close, further constraining over-investment and focusing managers' minds.

"These mechanisms illustrate how trade shocks influence corporate decision-making by reducing managerial discretion and directing resources towards more lucrative projects, thereby mitigating inefficiencies and improving resource allocation—in short, they serve as an external disciplinary mechanism that ultimately may benefit the companies," Dr. Sun said.