How do economic sanctions work? How do they not create an arbitrage opportunity?

Question

(Not sure if this should be on Politics.SE)

This is something I've been thinking about since the Russian invasion of Ukraine. Many countries enacted sanctions on Russia in response.

Let's say one of those countries (Silvonia) passes a law that prohibits sale of bullets to Russia. This creates an artificial shortage of bullets in Russia, and an artificial surplus of bullets in Silvonia. This sounds like a business opportunity for a third party: they can buy bullets from Silvonia and sell them to Russia. They might even make quite a bit of money this way, since the bullet-sellers in Silvonia have a surplus so they have to accept less money for their bullets, while the Russian buyers need the bullets so they are willing to pay more for them. Result: both Silvonia and Russia lose, third party makes money, and Silvonian bullets still end up in Russian weapons.

But if this is the case, then it hardly seems like sanctions make sense. Am I misunderstanding sanctions? Is there something that stops this scenario from developing?

Answer 1

As the other answer says the sanctions include prohibition on selling to third parties.

However, this still creates incentives to cheat on these sanctions. It is not always so easy to determine final destination of goods. It gets also easier to cheat on sanctions if some countries actually tacitly support the cheating here is an example of Russia doing so to undermine North Korea sanctions. It is harder to cheat if it’s not at least tacitly sanctioned by government but there always were and always will be smugglers.

However, one should not immediately jump to the conclusion that cheating means sanctions are absolutely ineffective. This is analogous to cheating on taxes. High taxes give people incentives to cheat on them, and some governments lose few % of revenue to GDP as a result, but that does not necessarily mean government is not raising a lot of revenue. Likewise, these workarounds can be thought of being a scalar that reduces the effectiveness of sanctions. It’s then an empirical question of how much.

Answer 2

The short answer is yes, the impact of sanctions (and other export controls) on the market prices of goods can create an arbitrage opportunity for someone willing to violate or circumvent those sanctions or controls. However, the legal framework around those sanctions and controls allows fines and penalties--up to and including prison--for anyone who improperly exports or improperly allows the export of a controlled item. Anyone looking to profit from the arbitrage opportunity must weigh the risk of those penalties against their potential profits.

I am not a lawyer, but I have done export compliance work for a company in the United States, and discussed our compliance obligations with experts from the US Department of Commerce, which administers export regulations for most commodity goods. I'm not familiar with other countries' export regulations, but I imagine they are similar in broad strokes.

Even aside from high profile sanctions such as have been imposed on Russia in response to their invasion of Ukraine, anyone who exports anything from the US is required to:

1. Know what export controls, if any, apply to the item to be exported
2. Know whether those export controls or any blanket controls are in effect for the destination country
3. Keep records of business inquiries and transactions involving controlled items or entities
4. Perform due diligence to confirm the identity of the end recipient (individual or organization) as opposed to the recipient of the initial export shipment
5. Check the end recipient against the list of entities who are subject to export controls (which is separate from the list of countries subject to export controls)
6. Obtain the required export license(s) before exporting any controlled item.

All of the above applies to both arms and commodity items, although arms fall under a different set of regulations and are handled by the Department of State. Failure to comply with these requirements, regardless of whether or not the exporter was aware of them, can incur stiff fines and even prison time.

Of course none of this makes it impossible to export a controlled item improperly, but it provides a legal framework to enforce export compliance along more of the supply chain between the manufacturer of an item and the person who wants it but isn't allowed to receive it. By making the seller of an item responsible for where it ends up (in a limited way, anyway), it incentivizes exporters to be on the lookout for straw buyers, and the requirement to keep records of their transaction allows authorities to investigate potential external violations of controls. It's quite common for those who sell controlled items--even domestically--to require their customers to attest that the item(s) will not be exported or re-exported as a condition of sale. Of course it's very easy to falsely attest that something will not be exported and then do it anyway, but it provides some legal cover for the seller by demonstrating due diligence and may allow them legal recourse against the customer who does so.

Some manufacturers go even farther, for example many precision machine tools must be reactivated by the manufacturer any time they are moved. There are some technical reasons for this, but it also makes it much harder to export and use those machines without the manufacturer's knowledge.

On the other side of the economic equation, these sorts of controls should, ideally, not be so onerous as to overly impede legitimate business. There is room to question the net benefit of any given export control regime in that light, but that's a more complicated question. There is also room to debate whether a given enforcement regime is adequate to outweigh the potential profit (through arbitrage or other means) of violating those controls to sufficiently discourage violations, which on the surface may be a simpler question, but ties back into the first of how that enforcement impacts legitimate business. That's a hard balance to strike and enforcement is never perfect anyway, so there will almost always be someone willing to take a risk if the potential reward is big enough.

Fundamentally, none of this is unique to sanctions or other export controls. Any legal restriction on the availability of an item can create an incentive--via increased prices--to sell that item in violation of those restrictions. The question of how a society keeps people from breaking rules even if the rules themselves create something of a profit motive to break them--in other words, how legal penalties are balanced against potential illicit gains--is pretty foundational to any legal system.

Answer 3

Sanctions always include prohibition of circumvention, so the Silvonian bullet seller is not allowed to sell to a third party if he has the slightest reason to assume that the third party just acts as an intermediary. See e.g. here.

Answer 4

Another piece of the puzzle: secondary sanctions

Say that Silvonia really wants to prevent bullets from falling into Russian hands. Silvonia can tell the world that anyone caught trading bullets to Russia, even if they have no connection to Silvonia, will be subject to Silvonian sanctions as well, as a penalty for undermining the overall sanctions regime. This can force people and businesses in a third country to make the choice between doing business with Silvonia or Russia; if access to Silvonian markets is important for them, they may choose to cut off Russia, which is exactly what Silvonia wants.

Answer 5

Even if you get a broker willing to circumvent the sanction (possibly even criminally in the source nation), it still makes the goods more expensive in the target nation. Before the target nation could buy direct, now they have to find some party to front the deal. That's going to add cost to any transaction. Money that could have been spent on something else.

Answer 6

Of course there is such an opportunity. Because this is economics, you mostly got legal arguments about a single country/economic space. But a lot of the politics around sanctions are about making this opportunity smaller and the political effects greatly outweigh any possible criminal activity.

It's important in this context to note that for most commodities, there is nothing preventing an actor from a third country which doesn't have sanctions from buying the commidity in Silvania and then selling it on to Russia. For the export of arms and dual use goods often there are conditions on re-sale which might possibly be enforced by contract law in the third country, but for most commodities that would be too much effort.

There is even a common term for such transactions in German, Umgehungsgeschäfte, maybe circumvention deals in English.

For example, when the EU passes sanctions, by default, they don't apply to Switzerland (in the middle of the EU). Sometimes, Switzerland decides to profit from this, sometimes they also pass similar sanctions. There is still always a delay before the EU sanctions are adapted to Switzerland and even after the delay, the laws might not exactly match and there might still be loop holes.