Cyprus Can Save Itself by Fleeing the Euro
Cypriots sitting in the cafes here on Nicosia’s Ledra Street are asking one another if there isn’t an alternative to their island’s bailout.
It has been just weeks since the series of rollercoaster negotiations that produced a deal to support Cyprus, in the process devastating its banks and economic prospects. After the initial shock, the reality of the agreement’s implications is sinking in.
The answer to their question is that there may be another way: Leaving the euro would be a better option for Cyprus if -- and only if -- it can secure cooperation from its troika of creditors: the International Monetary Fund, the European Commission and the European Central Bank.
To figure out whether they should stay or go, the Republic of Cyprus’s 800,000 people and their leaders need to first conduct a simple cost-benefit analysis of whether euro-area membership is worth it.
The pain inflicted by the terms of the $13 billion bailout deal will be huge. Cyprus’s banking sector has been all but destroyed in the course of just a few days. The second-largest bank, Laiki, was split into a good and a bad bank. The good assets, as well as about 9 billion euros in emergency liquidity that Laiki has received, are being moved over to the larger Bank of Cyprus Plc. Bondholders and uninsured depositors at both institutions will take hefty losses, destroying the economy’s offshore-finance business.
It remains unclear whether Bank of Cyprus will be solvent following its inheritance from Laiki. Even if it is, Bank of Cyprus is illiquid. The massive liquidity crunch in Cyprus is being exacerbated by capital controls, which the government imposed to avoid deposit and capital flight out of the country. Many businesses are unable to pay their suppliers -- one more month of such tight liquidity will push many into bankruptcy.
The banking sector accounts for only 9 percent of Cypriot gross domestic product. Yet business services attached to it -- lawyers, accountants, auditors and bookkeepers -- will suffer from the banking collapse, too. By some estimates, these services and banking generate as much as half of Cyprus’s gross domestic product.
The IMF forecasts that the country’s economy will contract 9 percent this year. The government is now predicting a 13 percent drop in output, but I expect the contraction to be sharper still. In this case, Cyprus will miss its deficit targets and will have to put in place more austerity in an attempt to catch up. The result will be an endless spiral of austerity and recession, ensuring that Cyprus will either need a second bailout or a debt restructuring.
Exiting the euro area is also difficult, but it could be the less painful choice if designed well. Among the greatest costs of any euro-area exit would be bank defaults on their liabilities, capital controls and a sovereign default. Cyprus has already experienced the first two and will most likely see the latter in the next year or two if it stays in the euro area.
So if Cyprus is going to incur some of the worst costs of abandoning the euro anyhow, it might as well print its own currency and benefit from a devaluation and the immediate boost in competitiveness that would follow. The island has three main industries that would do well if they were made much cheaper for foreigners: real estate (12 percent of GDP), tourism (about 7 percent) and business services (as much as 40 percent).
When it comes to leaving the euro area, however, choreography is key. A unilateral, disorderly default would be the worst possible option for Cyprus. Instead, this small country would need to negotiate its exit with each member of the troika of international creditors.
The main challenge is that if Cyprus were to reissue the Cypriot pound, the new currency would devalue significantly and drive up the inflation rate. This is a huge problem for a country that has to buy most of its raw materials and all of its energy from abroad, and has only enough foreign reserves to pay for a few weeks of imports. A bridge loan would be required to avoid facing power cuts and food shortages.
Luckily, the IMF exists specifically for this purpose, “providing resources to help members in balance of payments difficulties.”
An amicable divorce from the euro area would also need to be negotiated with the rest of the bloc’s members and the European Commission. There is no mechanism through which Cyprus could be pushed out of the European Union in retaliation, but given the serious threat that Turkey poses to the tiny island, Cyprus has a major geopolitical motivation for remaining fully engaged with its European partners.
Oddly, the one member of the troika whose blessing Cyprus wouldn’t absolutely require to exit the euro area is the ECB. So far, Cypriot banks have borrowed about 14 billion euros in emergency liquidity assistance and if Cyprus were to leave the euro area, this money would de facto represent a loss for the ECB. Still, Cyprus would want to negotiate a settlement with the ECB if it could, rather than push the loss onto the countries that recapitalize the central bank, angering them.
Put all of these elements in place and a negotiated euro-area exit is probably the lesser of two evils for Cyprus. It would be up to the members of the troika to cooperate, however, and that could prove a hard sell. The sums involved in facilitating Cyprus’s departure from the euro area would be small; the implications might be anything but. If larger euro-area countries were to seek the same treatment, it would be prohibitively expensive for the IMF, the European Commission and the ECB to cooperate.
Concern about opening that Pandora’s box might well prompt the three creditors to refuse to help Cyprus leave the currency area. In which case, Cypriots really are stuck.
(Megan Greene is a Bloomberg View columnist and chief economist at Maverick Intelligence. She is also a Senior Fellow at the Atlantic Council in Washington D.C. The opinions expressed are her own.)
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