Cyprus is edging towards euro exit

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.

Sources :
bbc.co.uk
reuters.com
Foxnews.com