Cyprus Endgame: The Killing of the Economy of a Small Country

by George_East on March 27, 2013

cyprus flagAfter two weeks of closure, Cyprus’ banks are due to re-open tomorrow.  At the time of writing this post it is not entirely clear whether they will.  Following the moronic original suggestion that €5.8Bn of a €10Bn bailout package was to come from ordinary deposits, even though EU wide insurance is supposed to protect deposits up to €100,000, an alternative deal was agreed between a fraught Cypriot President and the negotiators of the Eurozone Group of the EU.  

There were pretty wide spread reports on Sunday night (particularly in the well-connected Greek press) that President Nikos Anastasiades, who was only elected at the end of February, had threatened to resign if the EU continued to insist on the harsh terms that they were demanding as conditions of not pulling the plug on Cypriot Banks on Monday morning.

It the story is true, it makes one wonder what those terms were.  Because the deal that emerged from the negotiations, and to which Cyprus is now signed-up to, is utterly disastrous for this small Mediterranean nation.

Before looking at the detail, some perspective is needed.  The sums required to be provided by Cypriot depositors amounts to a tiny fraction of EU GDP.  €5.8Bn in the context of a €12.6Tn GDP economy is small change that would have been barely noticed had it been provided to the Cypriots by way of loan.   It was announced today, for example, that the EU’s budget is itself going to be increased next year by more than the total bail out costs.   

The terms of the deal, then, are not about whether the EU can afford to bail out Cyprus.  It could easily, without noticing.    That is not the point.  The reason that the EU (and in reality when we speak of the Eurozone Group of the EU we are talking about the Germans) have required the terms they have is because of Cyprus’ role as an offshore banking centre and haven for Russian money, much of it somewhat less than clean.   The crisis has presented an opportunity to close this down.  By treating Cyprus as harshly as they are, the EU also hopes to send a message to other smaller jursidictions with lax attitudes to the financial sector – there will be a good deal of anxiety in Malta and Slovenia for two as a result of this (there are even media reports of loaded Luxembourg shuffling in its shiny shoes, as it has by far the highest bank assets: GDP ratio).

 The desirable end of reducing the size of the Cypriot banking sector cannot though be a reason to destroy an economy, particularly given the collateral damage that it will cause to ordinary Cypriots who are no more responsible for the behaviour of Laiki and Bank of Cyprus than British citizens were for RBS and Lloyds TSB.  The EU welcomed Cyprus into the Euro as recently as 2008, when its role as an offshore banking centre was already known.  It did so with open eyes, it cannot, like Inspector Renault now pretend to be shocked (shocked I tell you) that there is banking going on, on the island.  It should have either been a process over time or the ECB should have taken the banks onto its balance sheet, effectively being the first EU-nationalisation.

The new deal for Cyprus is certainly better than the old terms.  No longer will depositors under €100,000 be affected (though the EU’s stupidity in being willing to do the original deal has made it absolutely clear that the insurance scheme is not worth the paper it is written on). 

However the impact of the terms will still be dreadful for Cyprus.  Laiki Bank is to be closed with its good assets moved to Bank of Cyprus.  The result of this will be that depositors in Laiki Bank with over €100,000 will be treated as creditors in the liquidation of the bank, like any other creditors.     Once the maths is done they may be completely wiped out, but in any event they are looking at haircuts of 30-40%, on the most optimistic views.   In the meantime Bank of Cyprus deposits over the €100,000 level will be frozen until it is determined whether a haircut is needed to ensure that the Bank meets high capital ratio requirements.  If you are a Cypriot lucky enough to have your deposits in other banks then there will be no depositor haircut at all.  But that does not mean you will escape the wider consequences of the deal.  Oh my goodness no.

Of course, as we know from the disastrous way in which Greece, Spain, Ireland and Portugal have already been treated, the package also comes with draconian austerity requirements of spending cuts and forced state asset fire sales.

The primary effect of the package will be to destroy over night one of Cyprus’s two major industries removing employment for thousands and a source of income for the state through taxation.  Estimates suggest that the effect will be a reduction of between an eye-watering 10-20% in GDP.  That is the kind of reduction that you might expect to see as a result of a war.  Moreover, Cyprus’ debt levels will jump overnight to 140% of GDP (roughly Greek levels).   Cyprus will be sent into a debt-austerity-debt spiral to economic penury.

Of course, what will inevitably happen as a result of this is mass capital flight which will destroy all that remains of Cyrpus’ financial infrastructure.   In order to prevent this Cyprus is introducing tight capital controls.  These will, amongst other things, limit the amount of money that can be taken out of the country to €1,000 per trip, a cap on all credit and debit card transactions of €5,000 per month, and limit cash point withdrawals to €300 per day.   It is said that they are temporary, that they will only be in place for 7 days.  No one seriously believes that is likely to be the case – they will be there for a long time.

All of this is necessary, says the EU, for Cyprus to be able to remain in the Euro.  But, of course, the imposition of capital controls means that Cyprus has for all intents and purposes already left the Euro.  There will be a Cypriot Euro and a rest of Eurozone Euro.  The notes and coins will look the same, but as the Cypriot Euro cannot be taken out of Cyprus other than in small amounts, it is not therefore freely convertible and it will have, in practical terms, a different value to that in the rest of the Eurozone.

This begs the question as to what on earth is it all for?  Why would Cyprus want to subject itself to economic destruction – to reverting to a semi-third world country of goats, olive groves and beaches in order to maintain the symbolic status of staying within the Euro.    Its far better course, as Paul Krugman set out in a great post yesterday on his blog, is to leave the Euro.   The banks should remain closed tomorrow and the weekend should be used to print the relaunched Cypriot pound at a pace, to be the new currency from Monday.  The currency will immediately collapse in value against the Euro, but in that, will be the seeds of a  recovery, that could never be achieved within the Euro.   It would allow Cyprus to do what Iceland did (the Icelandic Kroner dropped 40% in value) or what Argentina did in 2002 when the Peso’s peg to the dollar was removed.

Instead Cyprus has, probably out of pride and fear of the unknown, allowed itself to be ritually slaughtered by the Eurozone Group of the EU as a lesson to others.

{ 1 comment… read it below or add one }

Charlie_East_West March 27, 2013 at 9:54 pm

Completely agree. Leave the Euro, and do as they do in Iceland.
Why delay the inevitable?

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