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Cyprus’s Imminent Collapse

Wednesday, March 27, 2013

Any calm bought by the IMF-EU bailout package for Cyprus will be short-lived. Cyprus is all but certain to experience an economic collapse over the next two years, and the country will again question whether it should remain in the euro.

One has to pity Cyprus. It is all but certain to experience an economic collapse over the next year or two at least on the scale of that recently experienced in Greece. Cyprus is being subjected by its European partners to the same recipe of severe fiscal austerity within a euro straitjacket that produced an economic depression in Greece. It cannot devalue its currency as a means to boost its tourist sector, and must also cope with the imminent collapse of its financial sector, which is overly dependent on catering to Russian depositors.

The origins of Cyprus’s dire economic and financial situation can be traced to a lack of adequate supervision of its financial sector. Fueled by an influx of money from Russians seeking a tax haven, the Cypriot banking system was allowed to grow to eight times the size of the Cypriot economy. Compounding the economy’s vulnerability, Cypriot banks managed to invest the equivalent of 160 percent of Cyprus’s GDP in Greek government bonds. When the Greek government defaulted on its bonds, the Cypriot banks experienced a capital shortfall estimated at close to €9 billion, the equivalent of approximately half of Cyprus’s GDP.

The decision by Cyprus’s European partners to force Cyprus to bail-in its large depositors as a condition for an International Monetary Fund–European Union rescue package is almost certain to have killed Cyprus’s attraction as an offshore tax haven, especially to Russians. After being subjected to a 40 percent write-down of their bank deposits and strict capital controls on withdrawing their remaining deposits, Russians surely will have lost all confidence in Cyprus as a financial center. This will make them want to move their money out of Cyprus at the earliest opportunity, which is almost certain to result in a dramatic scaling down of Cyprus’s banking sector and its employees.

Cyprus’s financial sector will likely be halved — a crushing blow to the Cypriot economy. Services constitute around 80 percent of the Cypriot economy and the financial service sector employs a large percentage of the country’s labor force.

Being hit by a major financial supply-side economic shock would be bad enough for any economy. However, with the IMF-EU bailout package, Cyprus is being simultaneously hit by a major demand-side shock from severe budget austerity. Under its IMF-EU bailout support program, Cyprus is required to adopt budget austerity measures totaling 7.3 percent of GDP over the next three years. Of that budget tightening, around 3 percentage points of GDP are to be implemented in 2013.

The Cypriot banking system was allowed to grow to eight times the size of the Cypriot economy.

Recent experience in the rest of the European periphery would suggest that such a drastic degree of budget tightening could constitute at least a 4-percentage-point hit to Cyprus’s GDP. This would seem even more likely considering that, in order to improve their balance sheets, Cypriot banks will have to cut back heavily on credit to households and firms. Consumers’ confidence will also have been seriously impacted by the severe restrictions that were placed on their deposit withdrawals as well as by a domestic atmosphere of considerable political instability.

Over the past three years, the International Monetary Fund and European Union have proved to be consistently overoptimistic in their prognostications on the impact of their adjustment programs on the economies in the European periphery. It would seem that Cyprus will be no exception. While the International Monetary Fund and European Union are projecting that the Cypriot economy will decline by “only” 3.5 percent in 2013, given the very large supply-side and demand-side shocks to the Cypriot economy, it is far more likely that it will decline by a multiple of this projected amount.

Sadly, the probable collapse of the Cypriot economy over the next few months will bring Cyprus back into international focus. Not only will Cyprus fail to comply with the terms of its IMF-EU bailout program as its tax base is eroded by a weak economy, and not only will its banks experience larger loan losses than are being forecast, but anti-euro sentiment will be fanned as unemployment skyrockets. Questions will again arise as to whether Cyprus should remain in the euro. Already some 67 percent of Cypriots believe that their country would be better served if it were to leave Europe and throw in its lot with Russia. All of this suggests that any market calm that might have been bought by the IMF-EU bailout package for Cyprus will likely be all too short-lived.

Desmond Lachman is a resident scholar at the American Enterprise Institute.

FURTHER READING: Lachman also writes “Angela Merkel’s Cypriot Headache,” “The Biggest Loser: Europe and the Global Currency War,” and “No Easing in the European Crisis.” James Pethokoukis discusses why “Cyprus Offers a Scary Economic Lesson for America.” Kenneth Gould notes “Desperation in Cyprus Bank Deal” and John Makin examines “Cyprus Bailout: Raising the Stakes.”

 

Image by Dianna Ingram / Bergman Group

 

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