Friends by Sanctions: The Unequal Impact of International Relations on Trade and Welfare

This paper examines the impact of sanctions on trade, and how international relations influences the welfare implications of sanctions. Sanctions intend to punish target countries by inhibiting them from the gains from trade. The e↵ect of sanctions depends on not only the bilateral impact on trade but how much trade is diverted to other countries. I decompose international trade by the types of trade partners when countries are sanctioned, and empirically examine the impact of sanctions using a bilateral panel of all sanctions and trade between 1950 and 2005. To mitigate endogeneity, I focus on sanctions motivated by non-economic causes, such as sanctions imposed due to humanitarian or sovereignty issues unrelated to the target-sender trade relations. Sanctions reduce bilateral trade by 30%. The impact is larger for non-democratic countries at about 47%. Despite the large bilateral trade impacts, trade diversion mitigates the net impact of sanctions. Sanctioned countries increase trade with all countries that do not sanction them by 9%. The net e↵ect of sanctions is a 14% reduction in trade, with non-democratic countries asymmetrically being impacted. International relations’ role in trade diversion generates heterogeneous welfare consequences when countries are sanctioned. Trade between two non-democratic countries increases over two-fold when both are sanctioned by a third party country compared to when both are not sanctioned. However, such common enemy e↵ect is not found between democracies. In general, the political distance between two countries, measured by the absolute di↵erence in the democracy level, significantly impacts trade. Closer the two countries are on the political spectrum, the larger the trade amount is. This result holds in a tight structural gravity framework where I focus on the variation within country pairs. Ultimately, sanctions reduce welfare by about 0.5% in non-democracies using a method that summarizes welfare change from the change in trade openness. When I directly estimate the impact on real GDP per capital, which incorporates changes beyond trade openness, the impact becomes substantially larger with sanctions reducing welfare by 7%. Lastly, I find that target countries are willing to su↵er a 20% decline in GDP per capital before conceding to sanctions.