Unilateral and Extraterritorial Sanctions Symposium: Extraterritorial Sanctions – Overcompliance and Globalization

[Tristan Kohl Associate is a Professor of International Economics at the University of Groningen in the Faculty of Economics and Business.]

The Economics of Sanction Impositions

A central question in the study of international sanctions is if, and how, sanctions alter the incentives of economic agents in the sending country to do business with agents in the sanctioned, targeted state. In this regard, the empirical international economics literature asks whether sanctions are effective in changing economic outcomes such as international trade and foreign direct investment (FDI). The reasoning is that if economic operators – banks and other internationally active companies – stand to be penalized for doing business with operators in the sanctioned state, they will reduce these activities which ultimately has detrimental economic consequences for the target. Being cut off from foreign capital markets, buyers and suppliers, the economic harm that the sanction inflicts on the target changes its political economy incentives, inducing re-alignment of its policies with the intended objectives of the sanctioning state.

In international economics, analyses of how sanctions affect economic operators typically consider transactions in the sender-target dyad. Such studies can be roughly divided into two categories. On the one hand, large-N studies investigate the average effect of many sanctions that are aggregated across several different senders on many targets. For example, Felbermayr et al. (2020) and Kohl and Klein Reesink (2019) find that trade sanction impositions reduce international trade between senders and targets, but that the magnitude of these effects vary by the severity of the sanction in question. The effectiveness of sanctions on international trade also depends on whether senders can credibly signal their intention to impose a sanction, and their ability to actually do so. Moreover, Mirkina (2021) finds that sanctions do not lead to a decline in FDI.

On the other hand, the increasing availability of high-quality balance of payments and company-level trade data have recently led to numerous insightful analyses based on a specific set of sanctions imposed by one sender on one or a few targets. For example, Besedes et al. (2021) find that German sanctions are effective in reducing Germany non-financial companies’ financial transactions with target states. Crozet et al. (2021) show that French exporters were much less likely to export to Iran and Russia in the wake of EU-imposed sanctions. Kohl (2021) finds that U.S. sanctions reduce trade with targets; once these sanctions are lifted, U.S. exporters are in a stronger position to regain lost ground in the former target’s market compared to companies in the former target that seek to increase their U.S. market share.

Unilateral Extraterritorial Sanctions

Despite recent advances in collecting high-quality data on sanctions and quantifying their economic effects, the existing body of empirical work has largely overlooked the potential role of unilateral, extraterritorial sanctions imposed by senders outside of the traditional sender-target country-pair under investigation. In other words, when interested in quantifying the effect of country A’s unilateral, extraterritorial sanctions on country C, the researcher also needs to analyze not only how transactions between countries A and C are affected, but also how exchange between countries B and C are potentially affected. After all, the nature of extraterritorial sanctions is such they are designed to penalize any third-country operator engaged in transactions with operators in a targeted state. To the best of my knowledge, the economic consequences of extraterritorial sanctions has not yet been systematically analyzed in the empirical international economics literature.

In this regard, the contributions to Part II of Beaucillon (2021)’s Research Handbook on Unilateral and Extraterritorial Sanctions provide valuable insights into the administrative burdens, financial risks and legal challenges that companies from around the world have to consider when doing business with sanctioned economic operators. The issue at the heart of Part II is that of (over)compliance. The first half by Emmanuel Breen (chapter 15), Grégoire Mallard and Anne Hanson (chapter 16), Ilze Znotina and Paulis Iljenkovs (chapter 17) provides detailed examples of how economic operators seek to navigate extraterritorial sanctions through overcompliance. The second half by Marjorie Eeckhoudt (chapter 18), Jin Sun (chapter 19) and Eric De Brabandere and David Holloway (chapter 20) focuses on challenges that arise from litigation against extraterritorial sanctions. A key take-away here is that national courts vary in their procedures and interpretation of relevant laws when it comes to ruling on disputes, which subjects operators to substantial uncertainty in their commercial relationships.

My objective is to highlight various avenues for connecting the legal insights presented in the Handbook with theoretical insights and empirical knowledge in the international economics literature. Therefore, in the remainder of this discussion, I briefly describe the concepts of (over)compliance, and then apply overcompliance to existing models of international trade. In doing so, I will argue that overcompliance is not only costly from a monitoring perspective of the firm, but that it also induces negative welfare effects on society at large. Moreover, I will explain why overcompliance favors the largest, most productive multinational firms at the expense of smaller, less productive enterprises. Finally, I will highlight recent evidence on the economic cost of policy uncertainty, and argue that the economic cost of judicial uncertainty is likely to be sizeable. I conclude with some suggestions for further (interdisciplinary) research.

Overcompliance in a Globalized World Economy

Compliance is a necessary first condition to ensure that operators cannot be found to be at fault in doing business with a targeted entity. Yet, constantly monitoring and adapting to ad-hoc, complex and detailed sanctions impose a substantial cost to businesses that operate internationally. Over the past two decades, their production activities have become increasingly more fragmented throughout a complex supply chain spanning multiple countries, subsidiaries and external companies. The larger and more complex the supply chain, the more challenging it becomes for an economic operator to be fully informed about all the transactions completed between its suppliers, buyers and sub-contractors

As a result, operators opt for overcompliance, a situation in which companies take more extensive actions than strictly necessary to avoid risking a possible sanctions violation and hefty fine. In doing so, operators effectively limit their economic activities beyond what is strictly necessary under an extraterritorial sanction. Overcompliance may reduce the company’s immediate monitoring costs: categorically ruling out any business with anyone in the targeted state seems simpler than dealing with a host of exceptions to such a broad-brush rule. Yet, systematic avoidance of targeted operators and any other operators to whom they could likely be connected, all to avoid the potential scenario of risking a penalty, also cuts operators off from potential value-creating economic activities that would in effect not be a violation of any extraterritorial sanctions. Ultimately, overcompliance can do more economic harm compared to the gain of reduced monitoring costs stemming from opting for overcompliance instead of compliance.

Overcompliance and its Effect on Welfare

The economic burden imposed by overcompliance essentially is a welfare loss to society. This outcome can be analyzed using a standard textbook model in international economics to analyze import tariffs (by a small open economy).

Essentially, an extraterritorial sanction serves as an import barrier to the sender’s markets. If the United States imposes an extraterritorial sanction on Iran, a South African firm with business ties to both Iran and the United States needs to take measures to ensure that it is not in violation of the US sanctions at the risk of hefty fines and losing market access to the US. This increase in costs effectively reduces the firm’s export supply to Iran but also to the United States (where the exporter wants to reassure that it is compliant with US sanctions at the risk of losing US market access altogether). Restricted export supply raises domestic prices and reduces the amount of imports from the South African supplier. These developments give rise to so-called deadweight losses, i.e., inefficiencies imposed on the economy by restrictive regulations. Admittedly, it is empirically challenging to precisely measure the monitoring cost savings and deadweight loss of overcompliance. Nevertheless the essential point is that extraterritorial sanctions inflict economic damage not just on the target, but, rather paradoxically, also on itself when operators in third countries are (over)compliant.

Overcompliance and the Composition of Firms in International Trade

Aside from welfare considerations, overcompliance also affects the composition and share of firms that will be able to survive in international markets. The so-called Melitz (2003) model of heterogeneous firms argues that a company’s ability to engage in international trade is determined by its productivity. Moreover, the company incurs a fixed cost of entry for each foreign market it seeks to access through exports and through FDI. The main prediction of this model – which is robustly supported for a large number of developed and developing countries – is that only the most productive firms are able to recover the cost of entering foreign markets and to profitably engage in international trade and/or FDI. As a result, the vast majority of international trade transactions and foreign direct investment is performed by a small minority of multinational firms.

In the face of extraterritorial sanctions, (over)compliance in third countries with commercial ties to both the target and sender will face an increase in their fixed cost of entering/operating in these markets – regardless of whether these costs stem from increased monitoring, reporting, adjusting business practices and commercial relationships, incurring fines and/or litigation. Facing higher fixed costs, only the most productive firms will still be able to make a (smaller) profit in an increasingly hospitable market; less productive firms will see their profits decline and may be forced to exit the market. The net effect is that (over)compliance drives out less productive (i.e., less competitive) firms and increases the market shares of the ‘happy few’ firms that are able to survive in the market. So, while (over)compliance is a necessary precaution for third-country operators to minimize the risk of being penalized by losing market access to the sender, the Melitz model predicts that smaller, less productive firms will face a higher probability of making losses, withdrawing from international markets and even going out of business.

Judicial and Policy Uncertainty

Finally, uncertainty about the probability of incurring fines and uncertainty revolving around judicial dispute decisions imposes an additional cost on economic operators. Handley and Limāo (2015, 2017) find that policy uncertainty has a sizeable detrimental effect on a firm’s export investments and economic growth. While their research focuses on policy uncertainty regarding the creation of preferential trade agreements and China’s accession to the World Trade Organization, respectively, uncertainty regarding the judicial ruling on a policy’s implementation is likely to have a similar negative impact on economic growth. More generally, uncertainty about the formal and informal institutions governing international markets in which companies operate, raises their cost of doing business and limits their ability to engage in these markets.

Conclusion

This discussion aimed to establish linkages between unilateral extraterritorial sanctions, the concept of overcompliance and demonstrate applications to well-known theories and empirical results in international economics. One possible avenue for future empirical work is to quantify the extent to which extraterritorial sanctions impact international trade and FDI between the sender, target, and third countries. A challenge in this regard is developing a systematic overview of (the design of) extraterritorial sanctions. Second, the rapid rise of fragmented global supply-chains imposes a substantial monitoring cost on economic operators determined to be compliant with extraterritorial sanctions. A more informed analysis of the financial trade-offs involved between choosing for monitoring in the case of compliance versus overcompliance can contribute to our understanding of the (unnecessarily) inefficient monitoring burden that extraterritorial sanctions impose on foreign operators. Finally, the economic costs of overcompliance and ensuing judicial uncertainties may indeed be sizeable – even for the sending state. If so, we need to reconsider the usefulness of extraterritorial sanctions and the conditions under which alternative coercive and/or diplomatic tools may be more effective.