Economic sanctions on trade and financial activities are increasingly being used around the world. This column develops a model of international trade and macroeconomic dynamics to study the effects of sanctions that prohibit trade in certain goods and/or with certain agents. Trade and financial sanctions both lead to lower welfare for the targeted economy, regardless of exchange rate movements and after consideration of third-country effects. Still, sanctions can be made more effective, for example by forcing the sanctioned economy to reallocate resources toward sectors in which it is at a disadvantage and by coordinating with third countries.
Major geopolitical challenges have led to a significant increase in the use of economic sanctions, and the recent trend extends far beyond the number of cases during the Cold War era (e.g. van Bergeijk 2022 and Yotov et al. 2020). The sanctions imposed by Western nations on Russia following its invasion of Ukraine mark another milestone, with unprecedented and extensive restrictions placed on trade and financial activities.
There are two notable distinctions of the sanctions against Russia. First, they are a shift from blanket bans to targeted restrictions on specific agents, entities, sectors, and goods. 1 This reflects the distinction between how much to trade or whether to trade at all, at individual good or asset level, and/or with individual entities. Second, Russia is a sizable economy and a major producer of gas and oil. 2 Its deep integration into global value chains until its invasion of Ukraine highlights the importance of international interdependence as a determinant of the effects of sanctions, and the potential for them to have unintended consequences also on the countries that impose them.
A framework for modelling international economic sanctions
Against this background, a modern assessment of the impact of sanctions calls for a new framework that would account for the key distinctions outlined above. We offer our answer to this call in Ghironi et al. (2024a) by developing a model of international trade and macroeconomic dynamics triggered by sanctions that prohibit trade in certain goods and/or with certain agents. Our framework considers a world economy that consists of asymmetric, large countries, and it divides production between an upstream and a downstream sector. The former produces a homogenous commodity (e.g. gas) under perfect competition, and the latter produces differentiated consumption goods under monopolistic competition between heterogeneous firms. We assume country asymmetry by allowing one country to have comparative advantage in energy production, while the other(s) have comparative advantage in the production of consumption goods (Figure 1 summarises the basic structure of the model and its flows of goods, assets, and factors of production).
Figure 1 Model architecture
We consider two types of sanctions: trade sanctions and financial sanctions. Both imply exclusion of certain goods or agents from the international market. Financial sanctions prohibit access to international bond markets for a targeted group of sanctioned individuals. Trade sanctions, on the other hand, prohibit trade in selected individual goods, including gas. 3
Are sanctions an effective tool of geoeconomic power?
Initial media reports often relied on exchange rate fluctuations to gauge the effectiveness of sanctions on Russia. A strengthening rouble led some to believe sanctions were failing (e.g. Turak 2022). Furthermore, concerns arose that the EU might suffer as much as Russia (e.g. Cousin 2022).
The results of our framework suggest that early concerns about the effects of sanctions can be misleading. Simulation exercises involving goods trade, gas trade, and financial sanctions indicate that all types of sanctions lead to a significant fall in consumption and a sharp increase in labour supply in the sanctioned economy (referred to as ‘Foreign’ in our paper, ‘Home’ being the country that imposes the sanctions). These changes in Foreign consumption and labour supply translate into a pronounced decline in welfare. However, the real exchange rate reacts differently to several types of sanctions. As shown in Figure 2, the combined effect of import and export sanctions (in the form of excluding the products of the top 1% productive firms from international trade) generates a depreciation of the sanctioned economy’s exchange rate, while financial sanctions and gas sanctions cause it to appreciate. These findings confirm the finding in Eichengreen et al. (2023) and Itskhoki and Mukhin (2022) that exchange rates are not a good metric to evaluate the effectiveness of sanctions.
What drives exchange rate fluctuations in response to sanctions? Our framework links movements in the exchange rate to changes in relative downstream sector labour costs, average exporter productivity, and consumption composition across countries. The changes in average exporter productivity and consumption composition are most directly tied to the sanctions. For example, following export sanctions that prohibit the most productive Home firms from exporting to Foreign, average import prices in this economy increase because highest productivity Home exporters are those who charge the lowest prices. Moreover, Foreign consumers substitute the goods they no longer have access to with imports of other goods and consumption of domestic goods. Substitution toward imports of other goods induces less productive Home firms, which charge higher prices, to enter the export market. Substitution toward domestic goods includes domestic non-traded goods, which also charge higher prices. All these effects put upward pressure on the Foreign consumption price index, causing Home’s real exchange rate to depreciate, as seen in Figure 3.
Figure 2 Comparison of financial, trade-in-goods, and gas sanctions
Notes: Lines indicate transitional paths from no-sanction steady state to sanction steady state. Financial sanctions are exclusion of 90% of Foreign households from international bond trade. Trade sanctions are combined effect of import and export sanctions that are introduced with the exclusion of products of the top 1% Home and Foreign productive firms from international trade. Gas sanctions are a ban on gas trade. A negative deviation of the real exchange rate (RER) from the initial point indicates Home RER appreciation whereas a positive deviation indicates depreciation.
Who is most hurt by the sanctions? The sanctioned or the sanctioning country? A quantitative assessment within our framework shows that sanctions reduce welfare for both economies, but the sanctioned one suffers substantially more. This result from our research confirms the empirical finding of Imbs and Pauwels (2023) that Russia is much more affected by trade sanctions than the EU.
Sanctions hurt the most when less advantageous sectors are targeted and the sanctioned economy is forced to move resources into these sectors. In our model, sanctions that prohibit trade in final consumption goods lead to the most reshuffling between heterogenous producers in the final production sector of the sanctioned economy and disproportionately reduce the welfare of its population. Our results also provide backing for calls for more effective exclusion of Russia from international financial markets (e.g. De Luce 2022). We show that, for financial sanctions to be effective, the fraction of Foreign agents excluded from international bond trading must be very high. Otherwise, non-sanctioned agents end up engaging in international financial transactions also on behalf of the sanctioned ones, largely undoing the aggregate effect of the sanction.
Figure 3 Comparison of export and import sanctions on goods
Notes: Lines indicate transitional paths from no-sanction steady state to sanction steady state. Import and export sanctions are exclusion of products of the top 1% productive firms from international trade. Trade sanctions indicate the combined effect of import and export sanctions. A negative deviation of the real exchange rate (RER) from the initial point indicates Home RER appreciation whereas a positive deviation indicates depreciation.
International economic sanctions and third-country effects
It is often argued that the efficacy of sanctions is limited because they cannot be effectively enforced in an interconnected world due to trade substitution to third countries. This observation was first raised by Friedman (1980) during the Cold War. Current concerns of this nature are understandable as data reveal that several countries have been serving as logistics hub for re-export of Western goods to Russia since shortly after its invasion of Ukraine (Figure 4).
Figure 4 Russia’s exports and imports of goods other than mineral fuels and German exports
Notes: The figure plots Russia’s monthly exports and imports of goods to the selected countries and Germany’s exports to Kazakhstan and Kyrgyzstan from April 2021 to February 2023. Source: Zsolt Darvas, Luca Lery Mofat, Catarina Martins, and Conor McCafrey’s Russian Foreign Trade Tracker (17 May 2023), Federal Statistical Office Germany (4 July 2024).
Does this rerouting of trade imply that sanctions are ineffective? Not quite. Results from our other research (Ghironi et al. 2024b) show that while coordination between the West and the third countries would inflict more significant harm on the sanctioned economy, unilateral imposition of sanctions by the West still has a substantial impact.
Overall, sanctions hurt the target economy regardless of exchange rate movements and after consideration of third-country effects. However, this does not imply that sanctions cannot be made more impactful. Forcing the sanctioned economy to reallocate resources toward sectors in which it is at a disadvantage and collaborating with third countries could significantly amplify their impact in terms of economic performance and welfare. Importantly, coordination with third countries would make sanctions more effective, but our results also show the difficulty of achieving it, as, absent mechanisms that incentivise them to join a sanctioning coalition, third countries are better off remaining outside.
Source : VOXeu
