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Adjusting to Economic Sanctions
The document summarizes a study examining how Lithuanian food manufacturing firms adjusted to trade sanctions imposed by Russia in 2014 that banned many agricultural imports from the EU. The main adjustments included: - Reducing part-time employment as the most flexible margin of adjustment. Larger reductions occurred for firms more exposed to the Russian market. - Increasing exports to other countries to compensate for lost Russian exports. More exposed firms increased other exports more. - Decreasing investment and full-time employment for more exposed firms, though full-time employment adjustments took longer. A conceptual framework is presented predicting this sequence of adjustments, with part-time labor adjusting first due to lower costs, followed by exports, investment,
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Adjusting to Economic Sanctions
- 1. Adjusting to EconomicSanctions Povilas Lastauskas Queen Mary University of London, Vilnius University Aurelija Proškutė Bank of Lithuania, Vilnius University Alminas Žaldokas HKUST Bank of Estonia, Tallinn, Estonia *The views expressed here are those of the authors and do not necessarily represent those of the Bank of Lithuania or the Eurosystem **Support from Iceland, Liechtenstein and Norway through the EEA grants (project no. S-BMT-21-8 (LT08-2-LMT-K-01-073)) under a grant agreement with the Research Council of Lithuania is gratefully acknowledged
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- 6. The Event WeInvestigate I Russia-Ukraine conflict in 2014 led to political tensions between Russia and EU I EU financial sanctions on certain individuals in Russia I Response measures by Russia to ban of imports of agricultural, food product and certain raw materials (meats, dairy products, fruits, vegetables, etc.) from the EU, the US and some other countries in August 2014 I Initially announced for one year but then extended annually
- 7. The Event WeInvestigate I Russia-Ukraine conflict in 2014 led to political tensions between Russia and EU I EU financial sanctions on certain individuals in Russia I Response measures by Russia to ban of imports of agricultural, food product and certain raw materials (meats, dairy products, fruits, vegetables, etc.) from the EU, the US and some other countries in August 2014 I Initially announced for one year but then extended annually I Lithuania (part of EU) - small open economy: I Exports make 80% of its GDP I Russia has been one of the main trade partners for Lithuania’s agricultural and food product exports I 20% of Lithuania’s exports were directed to Russia I 18% of them were banned product exports I Food manufacturing sector affected most
- 8. Focus of OurStudy I Firm responses to a strong negative demand shock - adjustments along a number of dimensions I How and when do such adjustments interact and reinforce each other? I Is the heterogeneity of the adjustments limited to non-uniform adjustment costs and expectations of the demand shock permanence? I Are the changes limited to cost/input adjustments? How do firms switch to revenue adjustments?
- 9. Related Literature I Firmadjustments to trade shocks, mostly partial equilibrium: I Labor margin adjustments (Hogan and Ragan (1995), Mouelhi (2007), Fabiani et al. (2015), Asquith et al. (2019), Tanaka et al. (2019), Egger et al. (2020)); general equilibrium effects (Dix-Carneiro and Kovak 2019, Dix-Carneiro 2014, Caliendo et al. 2019, Dix-Carneiro et al. 2018) I Trade adjustments (Kee and Krishna (2008), Bernard et al. (2009) or Morales et al. (2019)) I Multiple adjustment margins (Bernard et al. (2006), Eslava et al. (2010), Bertola et al. (2012), Casacuberta and Gandelman (2012)) I Effects of trade bans, or severe trade restrictions: I US-China trade war (Selmi et al. 2020, Fusacchia 2020, Hanson 2020, Fajgelbaum et al. 2022) I Russia-EU trade sanctions (Crozet and Hinz 2016, 2020, Klomp 2020, Crozet et al. 2021)
- 10. Additions to theLiterature I Trade shocks are likely to be correlated with other economic adjustments or expectations; our paper presents a cleanly identified demand shock (sudden, unanticipated and abrupt) when the trade stops completely, holding other economics factors constant I Quite a bit is known about firm adjustments to trade liberalizations but: Liberalizations = – Sanctions? I Something is known about trade restrictions that affect firm adjustments on the intensive margin but how do firms adjust alongside several dimensions; how do they choose the adjustment margins and their sequence?
- 11. Main Results I Webuild an internally consistent conceptual framework to explain the empirical findings and derive new predictions: I Part-time labor, as the most flexible margin, adjusts first I Firms also revert to more active export redirection, if the shock is large I A larger and persistent shock leads to full-time labor and capital changes I Part-time labor adjustment also serves as characteristic of shock severity for the firm, capturing unobservable parameters
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- 13. Exports to Russiaof Banned Products I Banned product exports by the food manufacturing sector firms to Russia went virtually to zero:
- 14. Total Exports toRussia I Sanctions also completely cut food manufacturing sector’s total exports to Russia:
- 15. Total Revenues I Thatresulted in a drop in total revenues of food manufacturing firms (even if with a minor rebound later):
- 16. Empirical Strategy I Dataset- all firms in the economy: I Disaggregated balance sheet data I Detailed trade data by partner country, 8-digit HS product level I Treated firms: I Food manufacturing firms that had banned product exports to Russia in 2013 I Control firms (for each treated firm): I Food manufacturer that is also an exporter I Firm, closest in size (total sales in 2013) to the treated firm I Essentially, a triple-difference estimate of the import ban effects on treated firms in 2014-2017: I as compared to 2011-2013 I as compared to the respective changes in control firms I as compared to the respective changes in changes in corresponding firms with a smaller Banned export share
- 17. Main Specification I Reducedform difference-in-differences estimation: ∆Yi,t =β1 × Banned export sharei × Post2014t + γi + τt + ei,t I ∆Yi,t: difference in the adjustment margin Yi,t (part-time employees, full-time employees, investment, exports to other markets but Russia), where the difference is taken between the values of treated and the control groups I Banned export sharei : % of firm i’s exports of the banned products to Russia in 2013 over its total sales in 2013 I Post2014t: dummy equal to 1 in the years 2014-2017 and equal to 0 in years 2011-2013 I γi and τt: firm- and year-fixed effects
- 18. Part-time Employees (1) (2) Bannedexport share x Post 2014 -146.909*** -125.123** (50.223) (48.105) Banned export share x Post 2016 -56.133 (52.725) Constant 24.411*** 24.378*** (4.478) (4.474) R2 0.755 0.757 N 151 151 I Average exposed firm with 6.69% Banned export share reduced part-time employees by ∼10 (compared to the change in control firms), a 67% drop over the pre-period sample mean
- 19. Exports Outside ofRussia (1) (2) Banned export share x Post 2014 46.042** 19.626 (20.687) (24.308) Banned export share x Post 2016 54.657* (30.436) Constant -9.581*** -9.566*** (1.799) (1.807) R2 0.889 0.892 N 165 165 I Dollar value export adjustments to other countries than Russia
- 20. Investment (1) (2) Banned exportshare x Post 2014 -24.459** -26.798* (11.235) (13.657) Banned export share x Post 2016 6.103 (14.727) Constant -0.926 -1.274 (1.609) (1.772) R2 0.596 0.597 N 126 126 I A drop in investment for the food manufacturers
- 21. Full-time Employees (1) (2) Bannedexport share x Post 2014 -384.578** -128.022 (177.502) (159.867) Banned export share x Post 2016 -661.058** (314.478) Constant 141.696*** 141.306*** (16.923) (17.150) R2 0.953 0.956 N 151 151 I Average exposed firm with 6.69% Banned export share reduced full-time employees by ∼26 (compared to the change in control firms), a 6.8% drop over the sample mean
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- 23. Assumptions I CES demandstructure + Cobb-Douglas production function over part-time employment, capital and full-time labor I We adopt a simplified version of Helpman et al. (2010), where a firm exports its varieties in addition to selling on a domestic market I Our point of deviation includes firm-specific variable trade costs, e.g., reflecting efficiency in transporting goods, accessing customs, managing distribution network I Another extension is a possibility to export to Russia as well as to the rest of the world, rather than one foreign country
- 24. Primitives I The realconsumption index (Qt) is defined as follows: Qt = Z j∈J qt (j) σ−1 σ dj σ σ−1 , σ 1, where j indexes varieties; J is the set of all varieties; qt (j) denotes consumption of variety j; and σ governs the elasticity of substitution between varieties I The dual price index for the differentiated sector (Pt) is given by Pt = hR j∈J pt (j)1−σ dj i 1 1−σ I The domestic demand for variety j is: qt (j) = pt (j) Pt −σ Qt = At pt (j) σ , where At ≡ Q 1 σ t Pt is a demand-shifter, similarly to Helpman et al. (2010)
- 25. Firm’s Problem I Theproduction function is given by: qt (j) = K ψ t (j) LF t (j) 1−ψ φ LP t (j) 1−φ , for all firms producing varieties j ∈ J; φ, ψ denote distribution (share) parameters. As is standard, qt (j) denotes quantity, Kt (j) capital, LF t (j) full-time employment and LP t (j) part-time employment I Firms produce output to be used domestically, exported to Russia (RU) and the rest of the world (RW). The openness is summarized by: Υt (j) ≡ 1 + τ1−σ RU,t (j) A? RU,t At σ + sx RW ,t (j) τ1−σ RW ,t (j) A? RW ,t At σ ≥ 1 I We consider only those firms that are exporters to Russia, so there is no indicator function (in other words, we analyze firms conditional on exporting to Russia)
- 26. Firm’s Problem I Theper-period profit of a firm is given by: πt (j) = ( 1 + τ1−σ RU,t (j) A? RU,t At σ + sx RW ,t (j) τ1−σ RW ,t (j) A? RW ,t At σ # 1 σ × At ψK γ t (j) + (1 − ψ) LF t (j) γ φ γ LP t (j) 1−φ ! σ−1 σ − wF t LF t (j) − wP t LP t (j) − It (j) − ΦL LF t (j) , HF t (j) − sx RW ,t (j) fx (j) ) , where ΦL stands for a full-time labor adjustment costs function I The other notation is standard: It (j) stands for the firm j investment, HF t (j) denotes a change in full-time labor stock, and ΦL LF t (j) , HF t (j) takes full-time labor adjustment costs into account
- 27. Firm’s Problem I Ina perfect foresight environment, a firm is forward-looking and its profit maximization problem cannot be split into static sub-problems due to adjustment costs I A firm faces different adjustment margins I Part-time employees can be changed most quickly I Reflecting institutional setup, a firm is required to pay a severance payment when firing full-time labor, ending up in non-convex adjustment costs (see Bertola (2004) for the theory I Capital depreciates and investment takes time, implying that next period’s capital requires adjusting investment in the current period I The demand shock is modelled as a sharp increase in variable trade cost with Russia
- 28. Testable Implication I Proposition Anexogenous increase in trade costs with Russia induces layoffs of part-time employees. This effect is larger the larger fixed exporting costs and the lower variable exporting costs (and thus the larger export basket) to Russia had been before a shock Remark Part-time layoffs: ∂LP t (j) ∂τRU,t (j) = (σ−1)(1−σ)τ−σ RU,t fx wP 1−φ τ1−σ RW ,t A? RU,t A? RW ,t σ 0
- 29. Testable Implication I IOur empirical strategy is thus be based on the approximation: 4LP t ≈ (σ − 1) (1 − σ) fx wP 1−φ A? RU,t A? RW ,t !σ τRU,t (j) τRW ,t (j) 1−σ | {z } Rel.trade costs: RU/RW; 4τRU,t (j) τRU,t (j) | {z } Rel.change in trade costs w RU I A change in part-time labor is solely driven by a change in trade costs, adjusted by exogenous forces (from the firm’s perspective) I What matters is not only the relative magnitude of a trade costs shock (4τRU,t (j) /τRU,t (j)), but also how large trading costs with Russia are vis-a-vis the rest of the world (τRU,t (j) /τRW ,t (j)) I That is why we empirically use the banned share defined as a ratio of sales of banned products to Russia, compared to the total sales to other destinations
- 30. Testable Implication II Proposition Thelarger is the relative trade shock, the larger is the adjustment in the revenue share of the rest of the world Remark Elasticity of the revenue share of the rest of the world, after an increase in variable trade costs with Russia, is given by: ∂SRW t (j) ∂τRU,t (j) τRU,t (j) SRW t (j) = − ∂Υt (j)τRU,t (j) ∂τRU,t (j)Υt (j) 0, since ∂Υt (j) ∂τRU,t (j) 0. All else equal, trade reallocation to the ROW is larger if a firm’s openness sensitivity to trade costs was larger (i.e., 4τRU,t (j) /τRU,t (j) induced a larger adjustment in 4Υt /Υt; trade costs to export to Russia were smaller (lower τRU,t (j)); a firm had a larger revenue share with the rest of the world, to start with
- 31. Testable Implication III Proposition Aforward-looking firm reduces investment proportionally to a forthcoming drop in part-time employment Remark Firm’s capital adjustment is expressed as: 4Kt+1 = It = wP 1−φ ρ 1−ρ φψ4LP t+1 (δ = 0)
- 32. Testable Implication IV Proposition Thelayoffs of full-time labor are more likely, the higher are variable firm’s costs to trade with the rest of the world and the smaller is the stock of part-time employment Remark LF− t+1 (j) (1−ψ)φ(σ−1 σ )−1 = e Ψt τ σ−1 σ RW ,t+1 LP t+1 (j) − 1 σ ([1−φ+ψφ](σ−1)+1) Since: (1 − ψ) φ σ−1 σ − 1 0, σ−1 σ 0, and − 1 σ ([1 − φ + ψφ] (σ − 1) + 1) 0, the layoffs of full-time labor are more likely, i.e. a decrease in LF− t+1 (j), the higher are variable firm’s costs to trade with the rest of the world and the smaller is part-time employment
- 33. Taking Stock I Largershock makes firms reduce temporary workers quicker I Larger trade shock forces a larger increase in the trade share with the rest of the world I Due to forward-looking behavior investment is reduced straight-away (front-loading future costs) I Non-convexity in full-time labor produces a delayed reaction (once the shock turns out to be severe and persistent or if the persistence of the bad shock has been unforeseen)
- 34. Taking Stock I Largershock makes firms reduce temporary workers quicker I Larger trade shock forces a larger increase in the trade share with the rest of the world I Due to forward-looking behavior investment is reduced straight-away (front-loading future costs) I Non-convexity in full-time labor produces a delayed reaction (once the shock turns out to be severe and persistent or if the persistence of the bad shock has been unforeseen) I Adjustments start on the margin with no adjustment costs – part-time labor and continue onto less flexible and more costly adjustment margins
- 35. Role of Part-timeLabor I Heterogeneity of firm adjustments due to various unobservable characteristics hard to estimate empirically: variable exporting costs, time preference, expected probability of the shock persistence, and various adjustment costs I Yet, it can be captured by how strongly the firm adjusts on its flexible adjustment margin – change in the part-time labor
- 36. Role of Part-timeLabor I Heterogeneity of firm adjustments due to various unobservable characteristics hard to estimate empirically: variable exporting costs, time preference, expected probability of the shock persistence, and various adjustment costs I Yet, it can be captured by how strongly the firm adjusts on its flexible adjustment margin – change in the part-time labor I Empirically: additional interaction of the change in part-time employees over 2014-2015 to our dynamic specification: ∆Yi,t =β1 × Banned export sharei × Post2014t + β2 × Banned export sharei × Post2016t + β2 × Banned export sharei × ∆Parttimechange × Post2016t + γi + τt + ei,t
- 37. Role of Part-timeLabor – Result (1) (2) ∆FT empl. ∆Inv. Banned exp. share x Post 2014 -128.022 -26.798* (154.568) (13.679) Banned export share x Post 2016 -484.914* 7.230 (271.284) (15.670) ∆Part-time x Post 2016 -0.896 -0.097 (1.379) (0.077) Banned exp. share x ∆Part-time x Post 2016 22.104*** 0.744* (7.738) (0.408) Constant 142.967*** -1.056 (15.420) (1.839) R2 0.963 0.603 N 149 125
- 38. Role of TradeDiversion I Can the firms do something else when faced with the shock? I We test for the firms’ ability to adjust towards finding new export markets I Empirically: additional interaction of the change in dollar value of exports outside of Russia between 2013 and 2014 to our dynamic specification: ∆Yi,t =β1 × Banned export sharei × Post2014t + β2 × Banned export sharei × Post2016t + β2 × Banned export sharei × ∆NonRu export changei × Post2016t + γi + τt + ei,t
- 39. Role of TradeDiversion – Result (1) Full-time empl. Banned exp. share x Post 2014 -128.022 (163.557) Banned export share x Post 2016 -546.798** (261.905) ∆ NonRu exports (2013-2014) x Post 2016 -0.951 (1.053) Banned exp. share x ∆ NonRu exports (2013-2014) x Post 2016 25.454* (13.311) Constant 142.975*** (16.655) R2 0.958 N 149
- 40. Takeaways and Conclusions,I I A major sector of a small open economy lost its main export market for reasons unrelated to economic conditions I We apply reduced form difference-in-differences strategy to quantify the adjustment margins: part-time and full-time labor, investment, new export markets I We then build an internally consistent conceptual framework to explain the empirical findings and derive new predictions: I Part-time labor, as the most flexible margin, adjusts first I Firms also revert to more active export redirection, if the shock is large I A larger and persistent shock leads to full-time labor and capital changes
- 41. Takeaways and Conclusions,II I Part-time labor adjustment also serves as characteristic of shock severity for the firm, capturing unobservable parameters
- 42. Takeaways and Conclusions,II I Part-time labor adjustment also serves as characteristic of shock severity for the firm, capturing unobservable parameters I Economic policies of more flexible labor market or international trade support schemes could help ameliorate the shock effects: I Part-time labor as a shock absorber requires smooth and fast reallocation across fired labor, effective and accessible training policies, and labor market regulation admitting different types of work contracts I Subsidizing wage costs would reduce the shadow cost of labor and thus could prevent the lay-offs I Trade deregulation and the infrastructure to direct more products to existing and new foreign markets can help absorb trade shocks
- 43. Sequel... I In thefollow-up paper, we demonstrate that a negative impact for food manufacturers directly exposed to embargoed products creates a positive demand effect on the wholesaler sector
- 44. Sequel... I In thefollow-up paper, we demonstrate that a negative impact for food manufacturers directly exposed to embargoed products creates a positive demand effect on the wholesaler sector I The wholesalers’ ability to diffuse market entry costs across more export markets acts as a shock absorber for those producers who have been exposed to the sanction shock most, have exhausted other adjustment options, and have a limited history of exporting to alternative markets I One of the key policy priorities is to help exporters not only diversify foreign markets but also diversify modes of accessing foreign markets, including direct and indirect exporting
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- 46. References Bertola, Giuseppe, 2004,A pure theory of job security and labour income risk, Review of Economic Studies 71, 43–61. Helpman, Elhanan, Oleg Itskhoki, and Stephen Redding, 2010, Inequality and unemployment in a global economy, Econometrica 78, 1239–1283.