March 29, 2022

The traditional way nations settle disputes with each other when diplomatic efforts fail is to mobilise their armies and fight it out. While, sadly, this is still far too often the conflict resolution method of choice, other instruments were developed to force countries to change their behaviour that stop short of exerting physical violence. One such instrument is the application of international sanctions. Recently, and especially following Russia’s recent invasion of Ukraine this topic has taken centre stage for the world’s attention.

Sanctions are international political instruments and measures imposed on certain countries, territories, groups or individuals by other countries or international organisations. The purpose of sanctions is to change the behaviour of the target country, territory or group/person. Sanctions often impose strict obligations on companies and individuals and can have a significant impact on the economy. Sanctions are most effective if they are endorsed by the United Nations because of its members’ obligation to enforce them. Broadly speaking there are two types of sanctions: trade (or economic) sanctions and financial sanctions.

Trade/Economic Sanctions

Ever since in the 18th century British economist David Ricardo showed that countries always benefit from specialisation and economic cooperation, international trade between nations has become an important contributor to reducing global poverty, promoting economic growth, providing employment and enabling consumers to enjoy a greater variety of goods. Over time and once the mutual benefit was understood and accepted, trade volume increased exponentially. According to the World Trade Organization total trade in goods in 2020 topped USD 17,5 trillion in value, which is around 60% of global GDP, up from 27% in the early 1970’s. Globalisation has resulted in nations becoming highly economically interdependent. This mutual self-interest has helped over a billion people raise themselves from poverty and is a tribute to human ingenuity.

Given the enormous benefits of economic globalisation, it makes sense that decisions to impose international sanctions, which reduce trade and economic collaboration should not be taken lightly. It is not always well understood that, although not as physically destructive as traditional warfare, economic sanctions are not without costs or risks, for everyone involved. Aside from a reverse ‘Ricardo effect’, disruption in trade can have seriously negative implications for supply chain reliability and international trust between trading partners. And lack of trust increases the risk premium of doing business.

As international sanctions are political instruments, differences of opinion about their legitimacy can impact their effectiveness. There is no guarantee that other countries will share the political rationale for sanctions and target countries will look to exploit these differences and neutralise the sanctions intended purpose. As a sub-optimal impact of sanctions becomes clear, the temptation will be to add more and move towards a more limited kind of trade with military allies or more self-reliance, further threatening the economic benefits of globalisation.

That economic sanctions can cause severe hardship, not only on the target country, has become clear with recent energy and wheat price rises in Europe. The Economist estimates that a retreat to cold-war spheres or self-reliance would cause roughly USD 3 trillion of investment to be written off for less efficient production that fuels inflation and hurts living standards. Supply chains become stronger through diversification, not concentration.

Financial Sanctions

This second type of sanctions typically concern asset freezes, restrictions on payments to and from countries, on financial services and travel bans. Like economic sanctions, financial sanctions are a double-edged sword. Notwithstanding the moral satisfaction felt by impounding oligarchs’ yachts, the recent discussion about banning Russian banks’ access to SWIFT, the global financial messaging service is a demonstration of this duality. SWIFT is the nucleus of an efficient global payments system and restricting access to it invites the emergence of competitor services such as China’s Cross-border Interbank Payment System, CIPS. Another fun fact: as Western countries impose restrictions on USD and EUR payments this reduces these currencies’ appeal as preferred instruments for global payments and increases transaction risks for the US and Euro countries. According to Euromoney, the USD and EUR’s share of global payments by value is currently over 75%. Moreover, these currencies also attract the lion’s share of sovereign financial reserves. Such confidence in the soundness and reliability of these currencies has tremendous value and could be easily undermined if access to them is not assured under all but the most extreme (economic) circumstances.

Handle with care

In summary, to the extent they are an effective alternative for guns and bombs, economic and financial sanctions deserve a place in the diplomatic toolkit. And, to be fair, in the past sanctions have on occasion achieved their objective in modifying target countries’ behaviour without resorting to traditional warfare. That is an important benefit. But what is also important is to recognise that applying these diplomatic instruments is not without costs or risks. International sanctions are most effective when the objective is to encourage the target country to change its behaviour, not as a form of punishment. Also, they are best applied before a conflict becomes violent and when there is a broad consensus regarding their need. Also, they should be applied sparingly, wisely and proportionately to avoid jeopardising the very fabric of one of mankind’s greatest economic achievements.

Pieter van den Akker – March 2022