Why some firms comply with sanctions but others don’t

A new study reveals the effectiveness of economic sanctions varies depending on firm ownership amid geopolitical conflicts

By Sally Ho

Following economic sanctions imposed by Western countries on Russia for its invasion of Ukraine in 2022, questions emerged regarding how businesses respond to seismic geopolitical shifts. In these challenging circumstances, neutral countries are often caught in a bind to either comply with or evade the sanctions.

Naturally, questions emerge about the effectiveness of these sanctions and their impact on global supply chains. “Two distinct trade patterns emerged from our initial analysis: Sanctioning countries complied and their exports to Russia decreased, while neutral countries increased their exports to Russia,” says Wu Jing, Associate Professor in the Department of Decisions, Operations and Technology at the Chinese University of Hong Kong (CUHK) Business School.

This divergence drives him to dig deeper with more granular firm-level data. In a paper titled To comply or not to comply: Understanding neutral country supply chain responses to Russian sanctions, Professor Wu and his PhD student Zhi Li, in collaboration with Li Haishi of the University of Hong Kong and his PhD student Wang Yulin, as well as Park Ziho of National Taiwan University, examined two key mechanisms: extraterritorial export sanctions and financial sanctions.

Extraterritorial export sanctions are regulatory measures intended to restrict or prohibit the export of certain products to Russia, even if the goods are produced outside the sanctioning countries. The US spearheaded this initiative with its foreign direct product rules and entity lists, followed by similar measures issued by the EU, the UK, Canada, Australia, Japan, New Zealand, Norway and Switzerland.

Financial sanctions restrict access to the global banking system and trade, such as disconnecting Russian banks from international payment networks Swift and freezing foreign reserves of Russian financial institutions.

Professor Wu and his collaborators found a striking duality in the behaviour of businesses, depending on firm ownership. Multinational enterprises (MNEs) headquartered in sanctioning countries consistently reduced exports of sanctioned products to Russia by 34 per cent more compared to non-sanctioned products. This indicated compliance with extraterritorial sanctions and alignment with geopolitical mandates from their home countries, even when they were operating in neutral countries.

By contrast, domestic firms in major neutral countries like India, Pakistan, Vietnam, and Mexico significantly increased exports of sanctioned goods by 36 per cent. MNEs based in countries that have not imposed sanctions also increased their exports of sanctioned goods, though by a smaller margin of 6 per cent.

“Sanctions design should prioritise the strengthening of secondary sanctions to monitor trade routes and restricted market access to close existing loopholes.”

Professor Wu Jing

Different compliance between multinational and domestic firms

The researchers investigated export flows from firms across various countries and compared these flows before and after the imposition of sanctions. International transaction data was obtained from a supply chain intelligence platform S&P Panjiva, financial information from Orbis, and industry data from various sources. The analysis covered firms that traded with Russia from 2021 to 2023. Sanctioned products were identified using export control lists from the US Bureau of Industry and Security.

The analyses found that neutral countries took the opportunity to expand exports to Russia, thereby not only filling the void left behind by MNEs that abided by sanctions but also decreasing the effectiveness of Western sanctions. While sanctions may increase sourcing costs, Russia can still procure necessary goods from neutral countries, potentially undermining the sanctions’ objectives.

While MNEs based in non-sanctioning countries did increase their exports to Russia after the onset of the war, the analysis showed that domestic firms in neutral countries were the primary drivers of increased exports of sanctioned products to Russia.

A notable example is India’s largest privately owned conglomerate, Reliance Group, which initially only engaged in equipment maintenance and low-end parts supply for small and medium-sized Russian energy enterprises. Since the onset of the sanctions, its market share has jumped, and it has become one of the closest partners of Russian oil companies.

The growth of intermediary companies in Turkey illustrates this pattern well. Azu International, established in March 2022 in Turkey, quickly became a significant player, exporting at least US$20 million worth of computer components to Russia in just seven months.

Using a new decomposition formula, the team concluded that domestic firms contributed 145 per cent of the uptick in sanctioned product exports from non-sanctioning countries to Russia. In comparison, this figure for MNEs headquartered in sanctioning countries stood at a negative 51 per cent, as they decreased exports to sanctioned countries.

Domestic firms as growth drivers

Among domestic firms in neutral countries, consumer markets played a decisive role in shaping compliance behaviour. Firms that exported more to sanctioning countries reduced their exports to Russia due to potential penalties incurred for violating sanctions and the risk of losing access to the target markets. “Since they generate sales and profits in sanctioning countries, penalties against them are more enforceable,” says Professor Wu.

Conversely, firms that sourced inputs from sanctioned countries increased their exports of sanctioned products. “These firms were undeterred by secondary sanctions and likely rerouted imports from sanctioning countries to Russia, boosting their Russian sales,” he adds.

One interesting discovery is the duality in behaviour among MNEs headquartered in sanctioning countries. While it’s no surprise that these MNEs made adjustments to increase exports and seek out new buyers in their fellow sanctioning countries, they also simultaneously expanded exports to Russia-friendly countries.

The study found potential evidence of trade rerouting from MNEs headquartered in sanctioning countries to nations connected with Russia’s banking payment networks and allies, notably other former members of the Soviet Union. The researchers described this approach as one that blended compliance with potential evasion of sanctions.

Meanwhile, the team found that financial sanctions were particularly effective in decreasing imports from Russia by MNEs headquartered in sanctioning countries. This was particularly acute in sectors reliant on trade and finance, such as oil and gas, mining and raw materials, agriculture and food exports.

Implications for policymakers and future research

The study suggests policymakers consider the role of neutral countries to boost the effectiveness of future sanctions. “Our findings underscore the importance of MNEs and the extraterritorial reach of sanctions in geopolitical conflicts beyond the Russia-Ukraine war,” says Professor Wu.

In broad terms, the success of sanctions rests on policymakers’ ability to discourage domestic firms in neutral countries and MNEs based in non-sanctioning countries from trading with sanctioned countries. “Sanctions design should prioritise the strengthening of secondary sanctions to monitor trade routes and restricted market access to close existing loopholes,” he adds.

In the specific case of sanctions against Russia, the paper found that if domestic firms in neutral countries and MNEs based in non-sanctioning countries could comply as much as MNEs headquartered in sanctioning countries, Russia’s total imports of sanctioned products could see a 60 per cent cut and overall imports would fall by 38 per cent.

Looking ahead, Professor Wu notes that there is an opportunity to dive into the longer-term impacts that economic sanctions have. “Future research could explore the overall welfare effects and long-term implications for supply chain restructuring.”