EU Sanctions on Russia and Implications for a Small Open Economy: The Case of Cyprus

Abstract

This paper aims at assessing quantitatively the macroeconomic impact of EU sanctions against Russia for the economy of Cyprus. To this end, we use a medium-scale micro-founded DSGE model of a small open economy participating in a currency union like the euro area calibrated to the economy of Cyprus. The model features two sectors of production, namely the tradable and the non-tradable one. In this model, EU sanctions influence the sanctioning economy (i.e. Cyprus) through a mix of foreign shocks that hit in principle the tradable sector. In particular, to mimic the economic environment (namely, how all this started in 2022), we analyze first the effects of an energy-type shock modeled as a standard cost-push shock on imported goods. In turn, we add to this economic environment the impact of policy reactions like EU sanctions against Russia. In this context and given the strong trade ties of Cyprus with Russia, we model sanctions as two simultaneous negative exogenous shocks, that is, a temporary decrease in the exported goods, reflecting primarily reductions observed in tourism and financial services, and in inward foreign direct investment (FDI). Contrary to the mild impacts reported in the literature for the majority of EU countries we find non negligible negative effects for the economy of Cyprus which range from 1.24% to 3.13% in terms of average output loss in the short run. Given Cyprus’s vulnerable external position we show that the impact of sanctions depends crucially on the degree of tightening financing conditions which are likely to hit particularly more countries with high initial current account deficits and debt stocks.