The recent economic sanctions imposed on Russia and several other countries, including Syria, Iran, Venezuela, and North Korea, have reignited interest in the use of sanctions as a tool of foreign policy. While numerous studies have debated the effectiveness of sanctions on Russia, particularly during the initial phase in 2014, opinions remain divided. This column introduces a novel approach by which Russian firms might mitigate sanction risks by collaborating with partner countries that maintain friendly relations with Russia. The authors show that Russian firms exposed to sanctions in 2014 successfully leveraged these international connections to lessen the adverse effect of sanctions.
To reduce the effectiveness of sanctions on Russia, the Kremlin is known to have compensated targeted sanctioned firms through various channels. These measures include providing subsidies and loans for inputs and securing contracts for outputs (Nigmatulina 2022). Complementing this debate, Huynh et al. (2022) empirically show that Russian firms, particularly those related to energy and oligarchs, reduced investments and stockpiled resources in anticipation of foreign sanctions, suggesting preparedness for the Crimea event. Similar patterns in 2021, before Russia invaded Ukraine, indicate a strategic response to anticipated conflict. These studies echo the findings from Mamonov et al. (2021) that banks likely to be sanctioned in the future reduced foreign assets but unexpectedly increased foreign liabilities, with the impact varying significantly based on the banks’ proximity to Moscow.
Sanctions cause damage or losses to the targeted economies and have countereffects on the economies that impose them. For instance, there was a relatively modest $1.3 billion loss in trade, primarily due to narrowly targeted measures on specific goods (Bělín and Hanousek 2019). Interestingly, the study partially hypothesises that Russian firms might find close substitutes for the sanctioned products and services. Additionally, Western partners are legally permitted to continue business activities under contracts established before the sanctions were imposed. Crozet and Hinz (2016) critically examine this issue using data from French firms. Their analysis is particularly relevant given Russia’s subsequent retaliation with an embargo on European products. Building on this observation, Chowdhry et al. (2022) highlight the asymmetric economic costs of implementing sanctions for the senders and the potential responses within sanction coalitions through a burden-sharing mechanism. However, this study primarily focuses on the sanctioning economies, leaving open the question of how sanctioned economies and targeted firms strategically respond to these measures.
Why sanctions do not work: Evidence from international risk-sharing
In recent work (Duong et al. 2024), we show that Russian firms’ ability to diversify risks via countries friendly with Russia can significantly alleviate the negative impact of sanctions. In particular, we introduce a novel approach to measure Russian firms’ exposure to international risk-sharing by constructing indirect business relationships between Russian firms and their partners from friendly countries to identify the risk-sharing mechanisms of sanctions. The underlying concept of this approach is to determine the indirect connections between Russian firms and companies in nations that either abstained from voting or voted against sanctioning Russia in 2014 (i.e. friendly countries).
While firms can establish either direct or indirect business relationships with partners from friendly countries, the former presents a significant challenge when used as a proxy for risk-sharing. This is because Russian firms might select partners based on their business characteristics and fundamentals, potentially distorting the observed impact of the risk-sharing mechanism. We focus on indirect business relationships to address this, tracing Russian firms’ links through intermediary partners to firms in friendly countries. This approach allows us to use these indirect connections as a plausibly exogenous measure of risk diversification in 2014, which will be applied in all forthcoming empirical analyses. The concept of constructing the indirect relationship between Russian firms and their friendly firms can be visualised in Figure 1.
Figure 1 How to construct the indirect relationship between Russian firms and partner firms
We collect global supply chain data from the FactSet Revere database, which is commonly used to capture domestic and international supply chain relationships. Using these data, we identify first-level intermediaries and second-level business partners that Russian firms engage with annually, focusing on indirect relationships. Our main risk-sharing variable is the ratio of second-level relations with partners from friendly countries to the total number of relations. Firm-level financial data, including investments, leverage, and dividends, are sourced from FactSet Fundamentals, covering 2003-2023. After merging datasets, our sample consists of 9,735 firm-year observations from 241 unique Russian firms. In our subsequent analyses, we examine whether firms’ access to international risk-sharing through indirect business relations before the 2014 sanctions could mitigate their impact on Russian firms. Specifically, our models leverage the proportion of a firm’s indirect business relations with companies in countries that either abstained from or opposed sanctioning Russia in 2014 relative to its total business relationships at a given time.
Risk-sharing, sanctions, and firm investments in 2014
Figure 2 shows that Russian firms with established indirect relationships in friendly countries significantly increased their investments in tangible assets and capital expenditures following the 2014 sanctions. This risk-sharing channel helped firms mitigate the adverse effects of the sanctions. Specifically, a 1% increase in prior relationships with firms in friendly countries led to a 0.44% increase in tangible assets and a 0.67% increase in total capital expenditures post-sanctions, compared to firms without such access. The analysis shows no significant pre-sanction trends, confirming that this risk-sharing mechanism became crucial after 2014, enabling firms to increase their capital expenditures and investments in tangible assets despite the sanctions.
Figure 2 The impact of risk-sharing channels on firm investments
Notes: The figure shows the regression coefficients for the interaction between lagged indirect relationships and period dummies, accompanied by 90% (darker) and 95% (lighter) confidence intervals. The standard errors are robust, and the model incorporates all control variables.
By focusing on sub-samples where second-level partner firms are from Russia’s top trading partners, particularly India and China, we found that the risk-sharing channel is most effective when these relationships involve Indian firms, with significant positive effects on both tangible assets and capital expenditures. The effect is marginally significant for relations involving Chinese firms and other countries but is negligible when excluding India and China. To address potential biases from changes in business ties post-2014 sanctions, we re-estimated our model, excluding firms that altered their relationships after the sanctions. The results indicate significant positive effects on tangible assets and capital expenditures for firms that maintained stable indirect relations, underscoring the importance of pre-existing risk-sharing mechanisms.
Additionally, we explored the role of risk-sharing in mitigating the adverse effects of financial frictions, using low-dividend payout as a proxy for high financing frictions. Our findings show that firms facing higher financial constraints can better leverage risk-sharing to offset the impact of sanctions and increase investments. These findings have significant implications for Russian firms, as they highlight the critical role of international risk-sharing in helping them navigate the challenges posed by sanctions. Robustness checks, including analyses of the 2022 sanctions, the effects on other firm outcomes, and a counterfactual exercise using direct relations, further confirm the consistency of our results.
Conclusion
Given the nuanced effects of sanctions on targeted economies and the strategic responses they provoke, policymakers must refine their approach to sanctions. It is crucial to design sanctions that are more precisely targeted and adaptable to specific behaviours and practices rather than relying on broad economic measures that can be easily circumvented. Enhancing the sanctioning coalition, suggested by Chowdhry et al. (2022), is essential to closing existing loopholes that allow sanctioned entities to bypass restrictions, mainly through indirect business relationships with third-party countries that do not participate in the sanctions. Additionally, establishing robust monitoring frameworks to assess the economic impact of sanctions on both the target and sender countries will help minimize unintended adverse effects on domestic and global markets. This approach should also promote transparency and compliance within international trade and finance, ensuring the effectiveness and fairness of sanctions regimes.
Source : VOXeu
