Release or Repress? The Effects of Economic Sanctions on Capital Account Openness

Abstract

Despite the frequent use of economic sanctions by states, there are insufficient analyses of the collateral effects of these measures on target states. Under the sanctions, targeted leaders who pursue the longevity of their regimes adjust domestic policies to mitigate the costs associated with sanctions. Specifically, this article analyzes the effects of sanctions on capital account liberalization in target states. Economic sanctions trigger changes in the capital account openness of target states. However, the direction of the reform is dependent on the political institutions in target states, which characterize the behavioral incentive structure of the leaders. Specifically, economic sanctions lower capital account openness, albeit only in autocracies. Democracies, which are sensitive to the benefits of capital account openness, are less likely to tighten the restrictions. Instead, they are likely to open their markets. I employ the two-way fixed approach to test my argument, using time-series cross-sectional data spanning 145 countries for the period 1965–2005. In this regard, I find evidence in favor of my argument, with the findings suggesting the indirect impact of economic sanctions on target states’ financial policies on which the decisions are primarily driven by the political incentives of the targeted leaders.

A pesar del uso frecuente de las sanciones económicas por parte de los Estados, no existen suficientes análisis acerca de los efectos colaterales que tienen estas medidas en los Estados de destino. En virtud de las sanciones, los líderes de los Estados de destino de estas sanciones, que tienen como objetivo la longevidad de sus regímenes, ajustan sus políticas nacionales con el fin de mitigar los costes asociados a las sanciones. En concreto, en este artículo se analizan los efectos que tienen las sanciones sobre la liberalización de la cuenta de capital en los Estados de destino. Las sanciones económicas provocan cambios en la transparencia de la cuenta de capital de los Estados de destino. Sin embargo, la dirección de las reformas depende de las instituciones políticas de los Estados de destino, las cuales caracterizan la estructura de incentivos conductuales de los líderes. De manera más concreta, las sanciones económicas reducen la transparencia de la cuenta de capital, aunque solo en las autocracias. Las democracias, que son sensibles a los beneficios de la transparencia de la cuenta de capital, son menos propensas a endurecer las restricciones. En cambio, es probable que abran sus mercados. Utilizamos el enfoque fijo bidireccional con el fin de demostrar nuestro razonamiento, mediante el uso de datos transversales de series temporales que abarcan 145 países durante el período entre 1965 y 2005. A este respecto, encontramos evidencias que apoyan nuestro razonamiento, ya que las conclusiones sugieren el impacto indirecto que tienen las sanciones económicas sobre las políticas financieras de los Estados de destino, cuyas decisiones están impulsadas principalmente por los incentivos políticos de los líderes del Estado de destino.

Malgré la fréquence de l’utilisation des sanctions économiques par les États, les analyses des effets collatéraux de ces mesures sur les États cibles restent insuffisantes. Les dirigeants ciblés qui souhaitent assurer la longévité de leur régime ajustent les politiques nationales pour atténuer les coûts associés aux sanctions auxquelles ils sont soumis. Plus précisément, cet article analyse les effets des sanctions sur la libéralisation du compte de capital dans les États cibles. Les sanctions économiques déclenchent des modifications dans l’ouverture de celui-ci. Cependant, l’orientation de la réforme dépend des institutions politiques des États cibles, qui caractérisent la structure d’incitations comportementales des dirigeants. Plus précisément, les sanctions économiques réduisent l’ouverture du compte de capital, quoique seulement dans les autocraties. Les démocraties, plus sensibles aux avantages de l’ouverture du compte de capital, accentueront moins souvent les restrictions. Elles auront plutôt tendance à ouvrir leur marché. J’utilise une approche d’effets fixes bilatéraux pour évaluer mon argument, à l’aide de données chronologiques transversales couvrant 145 pays entre 1965 et 2005. À cet égard, je trouve des éléments pour étayer mon argument : les conclusions indiquent la présence de conséquences indirectes des sanctions économiques sur les politiques financières des États cibles. Les décisions concernant ces dernières se fondent principalement sur des incitations politiques des dirigeants ciblés.

Keywords:

• Capital account liberalization
• economic sanctions
• political institutions

Acknowledgement

I want to express my gratitude to the anonymous referees for their valuable feedback on the paper. Additionally, I am thankful for the research assistance received from the BK 21 Four Program of the Department of Political Science at Yonsei University and the Economic Statecraft Lab.

Disclosure statement

No potential conflict of interest was reported by the author(s).

Data availability statement

The data that support the findings of this study are openly available in the Harvard Dataverse at https://doi.org/10.7910/DVN/SAZO5V.

Notes

1 This does not imply that autocratic leaders are unconcerned about economic performance. They must also maintain sufficient resources to garner support from ruling elites. Nevertheless, the small size of their winning coalition incentivizes them to generate economic distortions and extract rents directed to their supporters (e.g., Milner and Kubota 2005). In contrast, democratic leaders, whose survival necessitates support from large portions of the population, find that maintaining benign economic conditions is a more efficient way to maximize the likelihood of being reelected (Bueno de Mesquita et al. 1999). Therefore, they are more likely to pursue economic policies that have fewer side effects.

2 The fact that democratic leaders are accountable to domestic lenders aids in addressing commitment problems in domestic debt issuance, enhancing the government’s ability to raise funds from the domestic market. However, this mechanism of accountability also renders leaders less inclined to borrow from domestic lenders who could swiftly penalize them during elections if things go awry. As a result, although democracies might possess greater capabilities to attract capital from both domestic and international lenders, the accountability mechanism encourages them to leverage the advantages of the latter.

3 Despite facing sanctions, these countries maintain channels for foreign capital. Previous studies, including Early (2009), Biglaiser and Lektzian (2011), and Lektzian and Biglaiser (2013), have demonstrated the limited effectiveness of economic sanctions in curbing foreign investment to targeted nations, sometimes even fostering capital inflows as sanction-busters seek to exploit economic rents resulting from the distortion caused by sanctions. Barry and Kleinberg (2015) also observe that investors approach third-party states to gain indirect access to the sanctioned countries. Consequently, external borrowing can serve as a dependable source of funds for countries even when they are under sanctions. Moreover, this approach can undermine the impact of economic sanctions by attracting sanction-busters or black knights and weakening international cooperation.

4 Although the TIES dataset encompasses both sanction threats and imposed sanctions, only the latter are employed in the analysis. This choice aligns with the theory, which focuses on the response of target states whose economies have been affected by sanctions.

5 The result of the estimation can be found in the Appendix (see Table A10).

6 This dataset encompasses the total debt amounts in developing countries, breaking it down into external and domestic debt components. I am grateful to Panizza for generously sharing this data.

7 Previous studies on economic sanctions state that multilateral sanctions initiated by international organizations (IOs) are much more effective in inducing target states’ capitulation than unilateral sanctions (e.g., Drezner 2000; Bapat and Morgan 2009). Therefore, I use IO Involvement as a proxy of the severity of sanctions.

8 Financial Development Index is drawn from IMF Data.

9 I refer to Akoto, Peterson, and Thies (2020) replication data for dyadic data.