The War in Ukraine and the Diminished Role of Economic Sanctions

In recent decades, scholars have argued that international trade and globalization promote peace among nations because war obstructs trade and thus carries increasing indirect costs (to be distinguished from its direct costs on human life and property). Russia’s decision to invade Ukraine in February 2022 seems to call these assertions into question.

Scholarly evidence indeed confirms that trade between belligerent nations declines during war, but belligerents usually do not trade much anyway, so such losses are effectively small. Russia’s trade with Ukraine amounted to about 4% of its total trade in the decade prior to the annexation of Crimea in 2014 and fell to less than 2% thereafter. The belligerents’ trade with third-party states is thus far more valuable, but it is not obvious that it falls too during war. Indeed, globalization may make third-party trade more resilient to war even for less globalized countries.

In brief, I argue that globalization makes it easier for states to substitute trade partners and obtain credit during conflict and thus makes it harder to employ trade sanctions. Consider three prominent aspects of globalization: the expansion of the World Trade Organization (WTO) regime, the relaxing of international financial regulation, and the increase in foreign direct investments (FDI). The expansion of the WTO regime, in both membership and scope, is commonly credited with facilitating the expansion of international trade and, by implication, increasing the indirect costs of war. Increasing internationalized capital mobility makes markets more sensitive to adverse news. Wars may thus result in swifter and economically more destructive flights of capital. A globalized economy is also associated with international production chains, mostly among subsidiaries of multinational corporations—vertical FDI. These chains compound any disruption to trade, as seen in the wake of the global financial crisis of 2008–2009.

Globalization therefore should increase the indirect costs of war. However, these same aspects of globalization (capital mobility, integrated production chains) also reduce other indirect costs of war, including trade with third-party states.

While WTO membership increases a country’s vulnerability by stimulating its international trade, it also decreases the indirect cost of war by making it easier to find new third-party trade partners as a substitute for ones lost. Indeed, Russia, which joined the WTO in 2012, increased its total trade from an annual average of about 350 billion dollars in 2004–2012 to about 400 billion dollars in 2012–2021, all the while decreasing its trade with Ukraine. Post-2012, Russia’s trade fell with 70 countries (including many Western countries, such as Argentina and Brazil) but increased with 115 countries, including Chile, China, Colombia, Egypt, Ethiopia, Indonesia, Iran, Kenya, Mexico, the Philippines, Saudi Arabia, South Africa, Thailand, Vietnam, and the countries of the Indian subcontinent. As an anecdotal example, in the second half of the 2000s, Russia imposed sanctions on Georgian wine as tensions between the two states increased. In response, Georgia, which had joined the WTO in 2000, diverted its wine exports to Canada, Cyprus, and Spain, and to Ukraine too, after the latter joined the WTO in 2008. Furthermore, the rules of the WTO formally constrain the scope of trade sanctions by nonbelligerent (third-party) member states.

The expansion of the WTO also affects nonmembers. In states that join the WTO, firms can better respond to a nonmember state looking for trade substitution during conflict, because they have already had to adjust to a competitive environment and join business networks. Russia’s commodities trade is especially easy to divert. In addition, in the globalized trade system that the WTO has spurred, governments hesitate to impose sanctions on any of the belligerent states—even if they are legal—lest firms from other states take up the forsaken trade.

Since 2014, Western nations have imposed various trade sanctions on Russia. Nevertheless, in addition to the countries listed above, Russia increased its trade with the Baltic countries, Bulgaria, Croatia, Cyprus, the Czech Republic, Ireland, Poland, Portugal, Romania, Singapore, and Switzerland. Either sanctions were not adequately enforced, or they were not sufficiently ambitious. The more developed the WTO system is, the greater the diplomatic and administrative effort needed to impose sanctions that are truly costly to the target.

Greater international financial openness increases the risk of capital flight during war, but it also improves the ability of firms, households, and governments to obtain credit from institutions in third-party states and even in belligerents, much like the trade substitution effect discussed above. Governments can impose selective capital controls to minimize the cost of war, restricting capital outflows (at least to some extent) without restricting inflows.

Indeed, Russia’s financial assets held in the West, most notably its central bank reserves, were frozen shortly after the invasion. Large Russian banks were excluded from the SWIFT global interbank payment system. The Russian currency exchange rate against the US dollar duly dropped by some 40% in 10 days, but it rose with the help of capital controls by some 50% of its prewar value as of the end of June. Russia forced some of its customers to pay in rubles for its energy exports. The necessity of keeping some Russian banks connected to SWIFT to allow such payments is one source of the sanctions’ leakage.

More importantly, when many countries liberalize their financial markets, a large, sophisticated, and liquid global money market emerges, with many internationally active credit institutions. The outbreak of any single conflict cannot easily disrupt such a market, which can handle many risks and offer finance even to risky clients with low credit ratings. Even governments prone to wars can get more credit. Of course, credit obtained during war should be more expensive than credit obtained in peace, but credit obtained during conflict should nevertheless be cheaper in a world with high capital mobility compared to a world with low capital mobility. Such access to credit can avert a collapse of the national economy and sustain trade levels.

The US has been trying to force Russia to default on its debt, by making it impossible for Russia to service its dollar-denominated debt. If that happened, Russia (its government and business sector) could still borrow in China and India, or draw down assets held in the Gulf states. Russian activity in crypto currencies is also expected to grow. But maybe they don’t need to try so hard, as Western-based banks, such as Raiffeisen Bank International and UniCredit, are still operating in Russia as of the end of June 2022.

Interestingly, Ukraine imposed controls on capital flows after Russia annexed Crimea. The recession and currency depreciation that followed necessitated debt rescheduling for Ukraine’s banks. Russian banks obliged and assisted in stabilizing Ukraine’s banks. In return, Ukraine refrained from action against major Russian banks operating in its territory. In addition, foreign banks already active in Ukraine committed to providing it with more liquidity. Bond issuance was not obstructed (although yields rose). Moody’s credit rating agency actually raised the credit rating of Ukrainian banks prior to the current war, another indication that wars do not necessarily cause financial destabilization in a globalized world.

Furthermore, rising global capital mobility makes trade sanctions less effective, as firms can better evade any government policy and are less compelled to act as tools of government foreign policies. Financial sanctions are often too blunt to be effective and too diffuse to be directed at particular targets. For example, financial sanctions were ineffective in preventing Chinese and Russian firms from operating in Iran and Libya. The sanctions did discourage the Russian state-owned energy corporation Gazprom from raising funds in the US, although it was successful in Europe. More recently, many German firms, such as Henkel, Bayer, Rohde & Schwarz, increased their investments in Russia even as the EU launched sanctions against Russia. Even as of the end of June 2022, Western and Japanese companies still operating in Russia included Ariston, Braun, Benetton, De Cecco, Fujifilm, Giorgio Armani, Hard Rock Café, Lacoste, Mitsubishi, Sbarro Pizza, Teva, and Tupperware.

While vertical FDI flows in and out of an individual state potentially increase the indirect cost of war as noted above, they also discourage trade sanctions, because they obscure the full effects of the sanctions. Action against trade with a target state may have adverse and possibly unexpected repercussions on the initiating party’s own industries, as well as on those of its allies, which may all be integrated into production chains with producers in targeted states. For example, during the 2012 tensions in the East China Sea, some Chinese government agencies initially encouraged consumers to boycott goods produced by Japanese corporations but backtracked when they realized that the same Japanese corporations were importing intermediate inputs from Chinese producers. Furthermore, a vertically integrated country could more easily compensate for lost trade by increasing trade within its production chains. In other words, production chains facilitate trade substitution in response to shocks such as war.

The expansion in horizontal FDI in and out of an individual state also mitigates the indirect costs of wars. Horizontal investments establish production facilities in a host country instead of exporting from the investors’ home country to the host country. In this way, horizontal FDI flows replace rather than enhance international trade. As a result, when a state receiving or sending horizontal FDI is engaged in war, there is less international trade for the war to disrupt. This is true even if the foreign investor quits the target country, leaving the production facility there. For example, Bayer ran a drug production facility in Russia. Without such a horizontal investment, it is very likely that Russia would have relied more heavily on imports of drugs, increasing its exposure to the risk of sanctions. While so far the Western-imposed sanctions list does not include drugs, it is possible that nonvital drugs could enter the list in the future, and/or that other sanctions effectively could curtail trade in drugs.

Furthermore, global vertical FDI can generate positive externalities for belligerent states even if they are less integrated in this way. First, a product is not complete until all its parts are assembled, including those coming from a country with relatively little FDI. Small parts can stall a big process. The wider the global production chains are, the more likely it is that interdependency will span even small input producers. Second, as global production chains expand, the number of states potentially affected by disruption in any single state increases too. All this creates strong corporate and national interests against trade sanctions.

An important caveat is that an increasing amount of international trade takes place in services, especially digital ones. Perhaps globalization does not reduce the cost of conflict to trade in services to the same extent that it does to trade in merchandise. Indeed, WTO trade liberalization in services lags behind liberalization in goods, and production chains are less important in services. Nevertheless, the discussion above highlights the enormous difficulty today in exploiting a country’s economic openness to cripple its economy during war, especially a large one such as Russia.

This is not a judgment over the wisdom in employing economic sanctions against Russia. Scholars have long noted that sanctions that impose costs on the initiating states can signal their political resolve to pursue their national interests. Such costly signals may be important in preventing further miscalculation and escalation. Western nations may also hope that in the long run Russia cannot win a second Cold War, having lost the previous one, which it started from a much better relative position than now. This indeed may be a long game. Although there may be political value in the economic disintegration of political systems that are incompatible with western values, the era of a pacifying globalization is over.