Recent years have seen a resurgence of political tensions between countries. While occasions when states threaten the use of military force are rare, diplomatic tensions are frequent. Flare-ups of disagreement or personal hostility between the leaders of two countries increases uncertainty of the future of bilateral political relations. At the same time, the proliferation of international supply chains has made the domestic production of goods increasingly dependent on inputs from foreign sources. By expanding their sourcing portfolio to foreign suppliers, firms and by extension entire economies are more prone to the trade effects of adverse bilateral political shocks.
The political fall-out of the poisoning of Sergei and Yulia Skripal is a case in point. In early March 2018 the former Russian spy and his daughter were poisoned with a military-grade nerve agent of a type developed by Russia.Footnote 2 The British Prime Minister made a statement in parliament, seeking an explanation from Russia.Footnote 3 By March 14, the UK had expelled 23 Russian diplomats who were identified as undeclared intelligence officers and had suspended all planned high-level contact. On March 17, Russia summoned the United Kingdom’s ambassador to Russia; 33 members of the diplomatic staff in Moscow were declared persona non grata, and were expelled from Russia within a week. The UK then closed its consulate in St. Petersburg, and the British Council office in Moscow.Footnote 4
Interestingly, as Fig. 1 shows, the incident may also have had a noticeable and peculiar impact on bilateral trade between the two countries. Figure 1a contrasts the UK’s (smoothed) imports from Russia against the imports by other European countries from Russia. The former shows a marked drop in total imports precisely around the time of the incident. Other European countries did not register such a decline. However, the impact on UK imports appears to have been heterogeneous across different types of goods, as depicted by Fig. 1b. Intermediate goods—those that are intended for use in the production of other goods in the UK—such as metals and mineral products, appear to have taken a much more severe hit than did final products, such as foodstuffs or machinery.
The aim of this paper is to investigate the impact of bilateral diplomatic relations on trade; we focus on why some sectors may be more sensitive than are others. We show in a stylized theoretical framework why certain industries may be more prone to disruption as a result of diplomatic tensions than are others, and we test the main hypothesis empirically.
The model assumes a two-sector and many-countries world, where a “diplomatic shock” may affect the sourcing decision of a representative firm for imported inputs. The model shows that this effect may be heterogeneous across sectors, even when the shock is homogeneous. The key determinant of the heterogeneity is the degree to which the imported input is used directly and indirectly in the production process, and whether viable alternative sourcing countries exist. The model thus captures an important feature of today’s global economy: Goods that are produced in one country are often used as an input in another country. Disruptions to trade—whether through an increase in tariffs or political tensions—thus do not only affect consumers directly, but also affect production of down-stream products.
We test the proposed mechanism in reduced form: We first construct a measure of the intensity of imported input use that follows from the model; we characterise how important certain imports are for certain countries. We then exploit variation in monthly data on imports and the incidence of bilateral diplomatic events. We use a novel dataset that records diplomatic events that are found in press releases that were collected from the websites of the foreign ministries of five politically and economically important countries: the United Kingdom, Germany, France, Japan, and Russia.
We contribute to the literature that studies the effect of diplomatic relations on trade. Measuring diplomatic relations and their evolution over time is challenging. Some authors have used direct measures of an increase in political ties, such as the presence of embassies (Rose 2007) or official visits of heads of state (Nitsch 2007). Others measure changes in political relations more indirectly: They use specific events such as the Dalai Lama’s visits to foreign countries (Fuchs and Klann 2013; Lin et al. 2019) or boycott campaigns (Heilmann 2016); voting similarities between countries at the UN General Assembly (Mityakov et al. 2013); or asylum policies (Cucu and Panon 2020). We add to previous studies by emphasizing the country-industry-specific heterogeneity of the impact, due to global value chains’ shaping countries’ dependence in imported inputs. We furthermore propose a novel measure that clearly identifies the beginning of diplomatic tensions with an official recorded action taken by a government.
The literature provides strong evidence that political relations affect trade. However, the underlying mechanism depends on the context: Heilmann (2016) shows that the effect on trade is driven mainly by changes in the attitudes of consumers; while in Fuchs and Klann (2013) the aggregate effect is driven by industries for which negotiations are carried out during the course of high-ranking governmental trade negotiations.
Most similar to our paper is the work by Michaels and Zhi (2010), who study the impact of the French opposition to the Iraq war in 2003 on bilateral flows between the US and France. They find evidence that French exports to the US dropped significantly—especially for intermediate inputs. Their finding is consistent with a change in managers’ attitudes towards France. Acknowledging the importance of intermediate inputs, we show in a simple framework that trade in inputs that are used intensively directly and indirectly by the importing economy are more prone to disruption by diplomatic tensions than is trade in other products.
Our paper also addresses the growing strand of the literature that stresses the role of uncertainty and changing expectations in shaping economic outcomes. One prominent example is the United Kingdom’s vote to leave the European Union, which affected important economic outcomes: stock market prices (Breinlich et al. 2018; Davies and Studnicka 2018); GDP (Born et al. 2019); and trade flows (Crowley et al. 2018). In another context, in relation to the sanctions against the Russian Federation in response to the events in eastern Ukraine and Crimea in 2014, Crozet and Hinz (2020) show that even products that were not directly targeted by any measure experienced a decline in exports to Russia. They show that those products that rely on trade finance instruments—e.g., letter-of-credit financing of a transaction—fared worse than other products.
Finally, the paper is related to a resurgence of interest in the evaluation of trade policy changes and disruptions to trade in a time of tightly-connected economies through global value chains. Two recent papers—Fajgelbaum et al. (2019) and Amiti et al. (2019)—study the impact of tariffs that were imposed by the Trump administration against China; the papers rely on state-of-the-art models that exhibit domestic and international input–output linkages. In a project that re-evaluates the results by Ossa (2014) and Felbermayr et al. (2013), who find surprisingly optimal high tariffs, Romalis et al. (2019) investigate optimal trade subsidies and tariffs in a world that is characterized by global value chains; they find—on average—much lower and, importantly, much more heterogeneous optimal trade policies across countries and industries. While our model sketches a more stylized view of the global economy, it shares this feature of domestic and international input–output linkages while investigating the impact of bilateral policies that impact trade.
The paper is structured as follows: In Sect. 2 we sketch a simple framework that formalizes the mechanism, where those imported inputs that are used intensively directly and indirectly in an economy are more sensitive to political tensions, given that viable sourcing alternatives exist. We describe the data we use to test this mechanism in Sect. 3, while Sect. 4 lays out the empirical strategy. The econometric results are discussed in Sect. 5, and robustness tests are discussed in Sect. 6. Section 7 concludes.