Cyprus is edging towards euro exit

By Hugo Dixon
April 8, 2013

Cyprus is no longer centre stage. Nicosia has agreed a 10 billion euro bailout deal with its euro zone partners and the International Monetary Fund. A visible bank run has been averted by stringent capital controls. International markets, which only ever suffered a mild bout of jitters, have calmed down.

But it would be foolish to forget about Cyprus. The small Mediterranean island is edging towards euro exit. Quitting the single currency would devastate wealth, fuel inflation, lead to default and leave Cyprus friendless in a troubled neighbourhood. Even so, the longer capital controls continue, the louder the voices calling for bringing back the Cyprus pound will grow.

President Nicos Anastasiades is against Cyprus leaving the euro. But the main opposition communist party wants to pull out. A smaller opposition group wants to stay in the euro but kick out the troika – the European Commission, the European Central Bank and the IMF. The country’s influential archbishop is also critical of the troika.

Anastasiades can hold the line for now. After all, he has just been elected and the constitution gives him huge power. What’s more, there are strong arguments for staying inside the single currency – not least the fact that, otherwise, it would lose the 10 billion euros (or nearly 60 percent of GDP) of bailout money.

If Nicosia brought back the Cyprus pound, it would plummet in value. Nobody knows how much, but economists guess it might be up to 50 percent. Cypriots are complaining at the massive haircuts suffered by big depositors in their two largest banks: Bank of Cyprus and Laiki. Such a massive devaluation would savage the wealth of all other depositors.

Meanwhile, devaluation would fuel inflation. Cyprus is a small open economy. All the oil is imported. Over 80 percent of the textiles, chemicals, electronics, machinery and automotive vehicles are imported too, according to Alexander Apostolides, a lecturer in economics at the European University Cyprus.

Cyprus also relies on cheap immigrant labour in its agricultural and tourism industries. Following a devaluation, their cost in local currency would rise. All this would mean that any gain in competitiveness would be eroded.

The island’s economy would suffer a further shock because it is running a current account deficit of somewhere around 5 percent of GDP. Given that Cyprus has limited access to hard currency reserves, this deficit would have to vanish overnight. Imports would slump. But so would domestic production, given its reliance on imports.

In such a scenario, Nicosia would not be able to avoid defaulting on its debts. Following a 50 percent devaluation, these would be double their current value when expressed in local currency. The debts come in two forms: the government’s own 15 billion euros of borrowings; and the central bank’s 10 billion euro emergency liquidity assistance (ELA) to the banks.

Default might seem an attractive option because Nicosia would suddenly shrug off a vast debt load. But it wouldn’t be that simple. It would face a slew of lawsuits. What’s more, if the central bank defaulted on its provision of ELA, the ECB would take the hit. The euro zone would not be happy and would, at minimum, insist on some sort of staged repayment plan.

Cyprus could, of course, refuse to pay point blank. But it is not Argentina. Its small size makes it vulnerable to being pushed around. If it tried to act tough with its euro zone partners, they would probably play hardball in return. They might even find a way to kick Cyprus out of the European Union.

Exit from the EU would be another blow for Cyprus. Its best trading opportunities are with the bloc. Most of the rest of the neighbourhood – such as Syria and Egypt – is not in great shape. And Turkey is off bounds until and unless some way can be found of resolving the dispute between Nicosia and Ankara over the latter’s occupation of the northern part of the island.

Cyprus will also struggle to exploit its offshore natural gas reserves if it quits the EU. Turkey, which is already trying to stop it, would find it easier to get its way if Nicosia was friendless.

Apart from all this, the country would have to decide how to run monetary policy.

A responsible government would want to contain inflation by either linking the Cyprus pound to another currency, such as sterling, or running a tight but independent monetary policy. In either case, Nicosia would have to keep interest rates high and curb its budget deficit. It might also need to maintain capital controls.

Such an austerity programme would be worse than that demanded by the troika. It would then be hard to avoid the temptation to print money. But that way lies hyperinflation.

So quitting the euro would not be a good choice. But staying is not a great one either. GDP could plunge around 20 percent over the next two years, according to the latest guesstimates. And the longer capital controls are in place, the more the Cypriot people will feel they are not in the single currency anyway – as a euro in Cyprus is not equal to one in the rest of the world.

The troika should help lift the controls as soon as possible. Otherwise, Cyprus may well quit the euro and, small though it is, that could destabilise the zone.

[The sixth paragraph of this story has been corrected to say that Alexander Apostolides is a lecturer in economics at the European University Cyprus. An earlier version of this article mistakenly stated that he is a lecturer at the University of Cyprus.]

 

3 comments

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Very nice, simple and straightforward article.
My point of view is suffer another 5 years in the eurozone, have a target of minimizing our debts and then exit the euro at a future date lets say another 5 years. Is that possible?

Posted by gooneraki | Report as abusive

no-no, Cyprus must give the same treatment to the ECB / IMF of what they gave to them: wait for the €10 billion and once that is in just CONFISCATE that money. That will also teach the ECB and La Lagarde a lesson.

Posted by Willvp | Report as abusive

Let’s review some of Mr. Dixon’s assertions, shall we?
(1) “Such a massive devaluation would savage the wealth of all other depositors.” – Laiki deposits over 100,000 have been wiped out. (They may get back 10-15% in 10 years’ time). Despite the smear campaign against Cyprus, most of that money is the working capital of local companies. These companies are for intents and purposes bankrupt. In BoC things are not much better: the confiscation will reach about 50% of “uninsured deposits”, 10% has already been released but is subject to capital controls and the rest will remain frozen until September. So, all companies having their working capital in BoC may not be bankrupt just yet, but will be starved to bankruptcy in the next few months. CONCLUSION: There is NO WEALTH TO BE SAVAGED left in banks.
(2) “Cyprus is a small open economy” – not any more it ain’t. It has ceased to be such since March 16th.
(3) “All the oil is imported. Over 80 percent of the textiles, chemicals, electronics, machinery and automotive vehicles” – absolutely true. Any hard currency will to diverted to the purchase of the absolute essentials – fuel, medicines etc. I guess we’ll just have to import fewer german cars, dutch TV’s and finnish mobile phones won’t we?
(4) “Following a 50 percent devaluation, these would be double their current value”. The real question is, what will the value of the debts be in 10-20 years time? With the GDP about to collapse by 20% in the next few years, won’t the government need even more financing form the Troika, given that its tax revenues will collapse? So, the difference may not be that great between the two scenario after all.
(5) “Exit from the EU would be another blow for Cyprus.” – nobody said exiting the EU. Just the Eurozone. After all, of the 27 member-states, currently 10 do have the Euro.
(6) “It might also need to maintain capital controls.” – capital controls will be here for a LOOOOOOOOONG time, whether in or out of the Euro.

So, unsavoury as the exit from the Euro might sound, the differences between staying and exiting would be, I’d wager, quite small. But devaluation would provide an essential tool that is currently missing from the arsenal of financial planners in Cyprus. So, in an effort to achieve a similar effect, they’ll savage people’s wages instead. Therefore, the effect to common folk is pretty much the same: keep the Euro and watch your purchasing power diminish through pay cuts and higher taxation, or leave the Euro and watch your purchasing diminish because of devaluation. 6 of one and half a dozen of the other.

Exiting the Euro would, however, have a distinct advantage over staying in the Euro: unemployment can be controlled much more effectively. All Cypriots will be earning less, but at least we won’t have a quarter of the population on the dole and we won’t end up having people scavenging garbage bins to find something to eat.

The Euro is NOT and SHOULD NOT be a sacred cow. If the Cypriot government has the best interests of the Cypriot people at heart then it MUST, at the very least, weight the two options and make an informed decision instead of simply proclaiming that “the Euro is non-negotiable”. And it should also have an exit plan in place, should we ever need it. As Mr. Dixon says, our presence in the Eurozone is not entirely in our hands.

Posted by yPapa | Report as abusive