Sanctions-Induced Network Reallocation in Small Open Economies: Evidence from Georgia, Armenia, and the Baltic States

Paata Sheshelidze

President and Co-Founder New Economic School – Georgia Tbilisi, Georgia

 

Abstract When sanctions raise the practical costs of direct trade and finance, do they simply shrink the targeted flows or do economic actors find workable alternatives? This study examines that question through the post-2022 sanctions environment, focusing on three small open economies –  Georgia, Armenia, and the Baltic states –  as living examples of adaptive human action. The central claim is that higher compliance and transaction costs alter relative incentives, prompting rational agents to reallocate activity toward lower-cost intermediary jurisdictions. Using structured comparative analysis of trade patterns, financial adjustments, and regulatory responses, the paper finds strong displacement dynamics in Georgia and Armenia, and a combination of domestic contraction plus outward reallocation in the Baltics. These patterns support a praxiological interpretation: sanctions do not eliminate actors’ objectives; they merely reshape the pathways through which those objectives are pursued. The result is a regulatory paradox –  direct restrictions often expand indirect routes. The study concludes with practical lessons for sanctions design and small-state strategy.

Keywords: sanctions, network reallocation, displacement, praxeology, small open economies, regulatory paradox JEL Codes: F51, F53, F14, B53, O19

Acknowledgements The author thanks colleagues at the New Economic School – Georgia and participants at the CIPE Regional Training on Illicit Flows & Corrosive Capital for thoughtful discussions and inspiration. All views expressed and any remaining errors are the author’s own.

 

1. Introduction Economic sanctions have become a primary instrument of contemporary statecraft. Over the past three decades, and especially after the dramatic expansion in 2022, they have largely displaced direct military confrontation as the tool of choice for exerting pressure (Hufbauer et al., 2007; Drezner, 2011). The 2022 package ranks among the most sweeping coordinated restrictions in modern history, touching trade, finance, technology transfers, and payment systems alike.

In practice, the global response was not simple contraction. Direct flows between sanctioning and sanctioned parties declined, yet third-country trade volumes rose in several regions. Fresh empirical records document clear geographic rerouting and sectoral shifts (Felbermayr et al., 2020; Global Sanctions Database).

This observation poses a straightforward but consequential question for anyone interested in how human beings actually conduct economic life under constraint:

Do sanctions primarily reduce targeted flows, or do they induce network reallocation through alternative channels?

Mainstream political-economy accounts often treat continued third-country activity as evidence of incomplete enforcement or institutional weakness. The recommended remedy is therefore obvious: tighten monitoring, expand compliance obligations, improve beneficial-ownership transparency, and intensify enforcement (OECD, 2015; Reuter, 2017).

A large body of research assesses sanctions by looking at aggregate outcomes – GDP contraction, bilateral trade decline, financial isolation, or political concessions (Hufbauer et al., 2007; Pape, 1997; Morgan et al., 2014). These studies typically assume a linear chain: restriction → contraction → pressure. Other work, however, has long noted that actors adapt, build evasion networks, and route activity through third countries (Early, 2015; Felbermayr et al., 2020).

Yet even this adaptive literature has remained heavily focused on whether flows shrink rather than on how they reorganize. Aggregate statistics may show partial decline, but they miss changes in network structure, intermediary centrality, mirror-trade asymmetries, and financial substitution. Consequently, we still struggle to separate genuine enforcement failure from systematic, incentive-driven displacement.

A praxeological perspective – centered on purposeful human action under changing constraints – predicts displacement rather than simple breakdown. When regulatory costs rise in one channel (legal exposure, compliance burdens, reputational risk, settlement barriers), practical agents compare alternatives. In a world of regulatory heterogeneity, substitute routes usually remain open. Activity is therefore redirected rather than extinguished. This logic echoes core insights from institutional economics and international political economy about regulatory arbitrage and jurisdictional competition (North, 1990; Simmons, 2001).

The real analytical gap is therefore not whether sanctions reduce direct flows, but whether that reduction reflects net contraction or redistribution across the network. Without examining these structural adaptations, we cannot properly judge the true incidence or long-term effects of sanctions.

This paper tests the displacement hypothesis in three small open economies that are especially sensitive to cross-border cost changes: Georgia, Armenia, and Estonia, Latvia, and Lithuania (the Baltic states).

Small open economies are ideal laboratories for observing practical responses because they depend heavily on external integration, face intense competitive pressure on regulation, and react quickly when transaction costs shift.

The paper contributes in three ways. First, it frames sanctions effects through a network-reallocation lens rather than a linear compliance model. Second, it supplies structured comparative evidence from precisely the settings where cost shifts are most visible. Third, it distinguishes compliance-induced contraction from incentive-driven displacement, clarifying a persistent conceptual ambiguity.

The central argument is straightforward: post-2022 adjustments in these cases are better understood as purposeful reallocation by practical actors than as mere enforcement failure. Regulatory tightening narrows direct channels, but the broader system adapts through intermediary expansion, financial substitution, and structural reconfiguration.

The paper proceeds as follows. Section 2 develops the praxeological framework and formalizes the hypotheses. Section 3 explains the research design. Section 4 presents the case analyses. Section 5 compares findings and draws policy lessons. Section 6 concludes.

2. Theoretical Framework: Incentives and Network Adaptation Sanctions do not erase economic objectives; they change the practical costs of pursuing them. From a praxiological standpoint, sanctions act as cost multipliers that reshape the environment in which human agents – traders, financiers, logistics operators – choose means to ends.

The relevant costs are concrete and multifaceted: legal exposure, compliance paperwork, payment frictions, reputational risk, and logistical hurdles. In everyday terms, sanctions make some routes more expensive or risky, prompting actors to search for cheaper or safer alternatives.

2.1 A Simple Cost-Substitution Framework Consider two channels:

• C₁ = total cost of the direct route
• C₂ = total cost of an intermediary (third-country) route
• Cₐ = one-time adjustment or switching cost

Sanctions raise C₁. Substitution occurs when C₁ > C₂ + Cₐ. The objective (obtaining inputs, reaching markets, earning profit) remains; only the pathway changes.

Elimination requires C₁ to exceed expected gains across all feasible channels –  an outcome difficult to achieve in a world of regulatory diversity. In practice, therefore, observed outcomes are usually reallocation, not disappearance.

2.2 Network Topology and Intermediary Centrality Trade and finance operate as networks of nodes (jurisdictions) and edges (channels). When costs rise at certain nodes, flows redistribute toward less constrained ones. Intermediary nodes with low regulatory friction and good connectivity gain centrality. The result is observable: new re-export hubs, fresh logistical corridors, and shifts in sectoral concentration – all driven by decentralized, practical decisions.

2.3 Financial Channel Substitution The same logic applies to finance. When primary settlement systems become costly or unreliable, agents shift to alternatives – intermediary banks, parallel clearing, or different currencies. Again, the guiding principle is practical cost minimization within available legal options.

2.4 Mirror-Trade Asymmetries as Signals Displacement leaves statistical footprints. Country A cuts direct exports to the sanctioned party B, but increases shipments to intermediary C; C then ships onward to B. Bilateral A–B statistics shrink, yet A–C and C–B statistics grow. Mirror asymmetries are therefore not noise but evidence of purposeful rerouting.

2.5 The Regulatory Paradox The framework reveals a practical paradox: policies meant to suppress specific flows reduce direct channels while increasing indirect ones. Tightening raises costs in targeted nodes, making alternative nodes relatively more attractive and encouraging greater structural complexity. Without coordinated closure of substitute routes, enforcement escalates complexity rather than eliminating activity.

2.6 Hypotheses From this praxiological foundation, four testable propositions follow:

H1: Sanctions increase intermediary trade intensity in jurisdictions with lower relative regulatory exposure. H2: Re-export activity rises in small open economies during the short- to medium-term adjustment period (2022–2024/early 2025). H3: Financial flows substitute toward alternative settlement systems when primary systems become cost-prohibitive. H4: Aggregate contraction understates systemic continuity because of network reallocation.

These hypotheses treat sanctions as changes in the action environment and outcomes as the aggregated result of countless individual adaptive choices.

3. Research Design This study uses structured, focused comparison to assess whether post-2022 adjustments are better explained by enforcement failure or by incentive-driven reallocation. The design is hypothesis-driven, applying the same set of praxiological indicators across cases that vary in regulatory stringency.

Case selection rests on three criteria: all are small open economies highly sensitive to transaction costs; all faced the same 2022 external shock; and they differ meaningfully in regulatory intensity (Georgia: liberal transit model; Armenia: hybrid expansion; Baltics: high-compliance EU regime). This “most-similar systems” variation isolates how institutional settings condition practical responses.

Analytical framework and operationalization The same five observable indicators are applied to each case:

1. Geographic trade reorientation (decline in direct flows + growth in third-country flows)
2. Re-export intensity (growth in sectors suited to transit)
3. Sectoral concentration shifts
4. Financial-sector balance-sheet changes
5. Domestic regulatory tightening measures

These indicators distinguish enforcement failure (persistence without systematic reorientation) from displacement (patterned, incentive-driven redistribution). The analysis focuses on short- to medium-term structural adaptation (2022–early 2025) and does not assume every growth episode is sanctions-driven; it seeks patterns consistent with purposeful adaptation.

4. Case Analysis

4.1 Georgia: Transit Amplification and Intermediary Centrality Georgia’s liberal trade regime, strategic location, and efficient logistics make it a natural low-friction node. Practical actors quickly exploited the cost differential created by sanctions.

Trade reorientation and re-export expansion Official Geostat data show automobile re-exports rising dramatically:

Year	Car Re-Exports (USD)	Share of Total Exports
2021	~457 million	~13 %
2022	~1.3 billion	~29 %
2023	~2.1 billion	~33 %
2024	~2.43 billion	~37 %

By 2024 cars were Georgia’s largest export category. Destinations shifted sharply toward Kyrgyzstan (USD 1.29 billion in 2024, +85 % year-on-year) and Kazakhstan, while direct shipments to Russia fell after 2023 restrictions. Mirror-trade discrepancies between Georgian exports to Central Asia and the importing countries’ records point to onward routing – precisely the pattern predicted by purposeful reallocation (H1, H2, H4).¹

(Trade and re-export data for Georgia are from Geostat (2021–2024). Armenia figures are from Armstat and the Central Bank of Armenia (2021–2024), supplemented by IMF Article IV consultations. Baltic non-resident deposit data are from Latvijas Banka, Eesti Pank, and Lietuvos Bankas annual reports).

Interpretation Georgia’s experience illustrates classic praxiological adaptation: traders, facing higher costs on direct routes, identified a lower-cost intermediary corridor and reorganized supply chains accordingly. No central coordination was required; decentralized cost–benefit calculations sufficed. The case strongly supports the displacement hypothesis and shows how regulatory friction in one node raises intermediary centrality in another.

4.2 Armenia: Financial and Trade Channel Adjustment Armenia combined trade reorientation with financial expansion, offering a clear window onto substitution in both domains.

Quantitative patterns Armstat and central-bank data record Armenia–Russia trade turnover rising from ~USD 2.6 billion in 2021 to ~USD 5 billion in 2022, ~USD 7.4 billion in 2023, and a record ~USD 12–14 billion in 2024. High-value imports (electronics, integrated circuits, machinery) grew disproportionately. Banking assets roughly tripled in 2022, profits surged, and remittances from Russia rose approximately 2.5-fold.

These shifts align temporally with tightened settlement costs elsewhere. Banks and traders, acting on practical knowledge of fragmented payment systems, diversified counterparties, currencies, and routes – textbook financial substitution (H3) and risk diversification under uncertainty.

Interpretation Armenia demonstrates how agents simultaneously adjust trade and financial channels when primary routes become costlier. The expansion reflects purposeful adaptation, not regulatory collapse. The case supports H1–H4 and highlights the dynamic, contingent nature of intermediary roles: they persist only while relative cost advantages remain.

4.3 Baltic States: Compliance, Contraction, and Outward Reallocation As EU members under stringent AML/CFT regimes, the Baltic states raised domestic transaction costs through tightened KYC, beneficial-ownership rules, and de-risking of high-risk non-resident portfolios.

Financial contraction Latvijas Banka data show non-resident deposits falling from 40–60 % of total deposits before the major tightening waves to below 20 % afterward. Similar portfolio reductions occurred in Estonia and Lithuania. High-risk cross-border segments contracted; flows migrated outward to jurisdictions with lower compliance friction.

In praxiological terms, the Baltic states deliberately increased C₂ (domestic costs) enough to reverse the substitution inequality inside their borders. Domestic intermediary roles shrank, but the underlying objectives of counterparties were met elsewhere –  illustrating conditional displacement (H4).

Interpretation The Baltic experience shows that strong regulatory action can produce local contraction without global elimination. It reinforces the framework: outcomes depend on relative costs across the entire network, and regulatory intensity merely determines the direction of reallocation.

5. Comparative Findings Across all three cases the same mechanism appears: regulatory tightening alters relative costs → practical actors reallocate toward lower-cost nodes → network structure changes. Georgia and Armenia absorbed expanded intermediary functions; the Baltics shed them domestically while contributing to outward displacement. The variation is systematic, not random, and tracks differences in regulatory friction.

The patterns fit the substitution conditions far better than an enforcement-failure story. Direct channels contracted where costs rose; alternative channels expanded where costs remained comparatively low. Aggregate statistics therefore understate systemic continuity (H4). The regulatory paradox is visible at every turn: tightening one node often strengthens others.

6. Policy Implications From a praxiological standpoint, sanctions are interventions in an adaptive system of human action. Policymakers who ignore substitution incentives risk changing geography without reducing overall activity.

Key practical lessons include:

• Sanctions design must be network-aware, targeting not only direct links but potential intermediary choke points.
• Escalatory regulation often yields diminishing returns once actors have optimized alternative routes.
• Small open economies face a genuine trade-off between regulatory credibility and competitive advantage; over-tightening can erode the very attributes that attract reallocated flows.
• Targeted, intelligence-based supervision is usually more effective than blanket escalation because it minimizes unnecessary cost distortions that drive wholesale substitution.
• Multilateral harmonization of substitute channels is essential if contraction rather than mere redistribution is the goal.

Ultimately, incentives – not intentions – determine outcomes. Policies that overlook how real actors respond to changed constraints may achieve symbolic success while producing unintended structural complexity.

7. Conclusion This study asked whether post-2022 sanctions primarily contracted targeted flows or induced purposeful reallocation across networks. Comparative evidence from Georgia, Armenia, and the Baltic states shows the latter: economic actors, guided by practical knowledge and cost–benefit calculations, redirected activity toward lower-friction pathways. Georgia amplified its transit role, Armenia combined trade and financial substitution, and the Baltic states demonstrated compliance-driven domestic contraction accompanied by outward displacement.

The core praxeological insight is simple yet powerful: sanctions change relative costs; relative costs reshape incentives; incentive shifts reconfigure network structure. Aggregate contraction metrics therefore risk misrepresenting real effects. The regulatory paradox –  direct suppression breeding indirect expansion – emerges as a predictable feature of open, heterogeneous systems.

Limitations and Directions for Future Research This study is primarily qualitative and comparative, relying on structured case analysis and post-2022 observational patterns. Future research could usefully extend the framework through econometric estimation of reallocation elasticities, formal network modeling of intermediary centrality, or micro-level studies of firm decision-making under sanctions. Applying the praxeological lens to additional regions (Central Asia, Middle East, Africa) would further test its generalizability.

By reframing sanctions through the lens of human action and network adaptation, the paper offers a more realistic basis for both scholarly assessment and policy design. Future work could formalize these dynamics with network models or estimate reallocation elasticities econometrically. In an interconnected world, understanding how actors practically navigate constraints remains the surest guide to effective action.

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