Cyprus Commits Economic Suicide

by: Shareholders Unite

The euro (or European Monetary Union, EMU) has proven to be an unmitigated disaster. Rather than providing economic stability and prosperity, it has produced exactly the opposite. As the eurozone limps from one crisis to another, the bleeding in much of the periphery (and a fair part of the center as well, see the recessions in countries like France and the Netherlands) goes unmitigated and the proverbial recovery that was supposed to be just around the corner remains just that.

Really only Germany has greatly benefited from the euro. While capital inflows to the periphery whacked its competitiveness out of sync with Germany (rather than leading to an appreciation of its exchange rate), it also produced demand for German exports. While the boom times are definitely over in the periphery, much of the difference in competitiveness remains, and the way the eurozone authorities are dealing with that, through adjustment of the periphery only via a process called 'internal devaluation' is very arduous and painful.

Even Germany faces substantial risks. Germany is liable for potentially very large sums of money in guarantees of different rescue funds (EFSF, ESM) and ECB bond buying and Target 2 imbalances, when the whole thing will really go wrong, something which can't at all be excluded.

Nobody in his right mind would want to join the euro, one would hope to think, although Poland seems to have a different take on it. However, splitting up the euro is rather complicated; we've likened that to unscrambling of an omelet. There is a classic paper by Barry Eichengreen about just how difficult this is:

Leaving would require lengthy preparations, which, given the anticipated devaluation, would trigger the mother of all financial crises. National households and firms would shift deposits to other Eurozone banks producing a system-wide bank run. Investors, trying to escape, would create a bond-market crisis.

Eichengreen concludes from this that:

The decision to join the eurozone is effectively irreversible. However attractive the rhetoric of defection is for populist politicians, exit is effectively impossible

Which is the point where we arrive at Cyprus. If there ever was a moment for Cyprus to leave the euro, it would be right now. It already has a banking crisis, and it has put in place the kind of restrictions on bank deposits and even capital flows that a country would have to embark upon if it were to leave the euro. Cyprus especially suffers from the disruption and chaos that accompanies such measures. Why waste such a golden opportunity?

As the saying goes, each crisis is also an opportunity and in a strange way, Cyprus is now in the rather enviable position that it can decide on the pros and cons of staying in the eurozone almost entirely on the merits of the arguments. Most peripheral countries do not dare to venture here out of fear of triggering the financial chaos that Cyprus is already experiencing anyway.

So a more dispassionate assessment can be made about the pros and cons of staying versus leaving the eurozone.

Cyprus business model
What has effectively happened is that in return for a rescue package, Cyprus has to abandon its business model, or at least the large part of it that relied on being an offshore tax haven. We agree with the eurozone authorities here, we have to say.

It was a rather ridiculous situation, having banks that are almost entirely deposit funded, attracted by secrecy and sky-high interest rates, swelling to eight times GDP.

However, whatever the (rather dubious) merits of that business model, if Cyprus wants to continue as an offshore tax haven, its only chance would be outside the eurozone, not within it.

Cyprus is faced with financial chaos, the implosion of its main business model, and the cost of the bail-out. The result of this is, in all likelihood, an economic depression on the scale of Greece, if not worse.

The boom years made the country uncompetitive in much else but banking. The prospect is now for the same protracted 'internal devaluation' in order to restore competitiveness, but the deflationary policies necessary to achieve this will only worsen the slump and explode the debt.

Our 'exhibit A' here is Iceland. It embarked on a similar business model (offshore banking), these banks ballooned, then imploded, and for a while it seemed like Iceland was sinking into the Atlantic ocean. However, Iceland did have one big advantage, it wasn't a member of the eurozone.

That enabled it to thumb its nose to foreign deposit holders without having to embark on the distinctly dubious pleasure of having to accept a strangulation type bail-out from the eurozone paymasters. And most of all, it enabled Iceland to embark on a large devaluation that made other sectors of the economy competitive.

You might want to consult this article by Dan White about the differences in handling a similar crisis between Ireland (within the eurozone) and Iceland (outside it). The question which country fared better really isn't so hard to answer. Here is what happened to Ireland:

Since putting the taxpayer on the hook for the banks' debts, the domestic economy has shrunk by almost a quarter in nominal or cash terms. And any real recovery is still a long way off.

Compare that to Iceland:

Way out in the North Atlantic, things have turned out rather differently. Economic growth is expected to be 3.1 per cent this year and 2.2 per cent in 2013. But surely after stitching up its bank creditors - the Icelandic banking default cost $85bn, a massive amount for a country with a population of 320,000 people - the country remains persona non grata with the international financial markets. Having been so badly bitten once, the markets must be twice or even thrice shy of Iceland. Not so. The Icelandic treasury successfully flogged $1bn of 10-year bonds to investors in May. These bonds were initially priced to yield a spread of 407 basis points (4.07 per cent) over comparable US treasuries, a margin which has since narrowed to 296 basis points.

Even Icelandic banks are returning to the markets. The differences in the fate of Iceland and Ireland are highly telling, as all three countries experienced a similar banking crisis. If anything, Ireland actually had the better starting position as it has other viable sectors and a rather flexible economy with a budget surplus and low public debt (at the outset of the crisis). It was often held as a model economy.

Public debt is going to explode to something like 140% of GDP as a result of the bail-out. Since this (as well as private debt) is in euro, this would explode much higher still after leaving the euro and a large devaluation. But debt is going to explode anyway, as the deep and protracted crisis will make the debt burden untenable and Brussels induced austerity will do the rest.

What are the advantages of staying in the euro?
That's a relevant question, and one we struggle to answer, to be honest. One could argue that the EU rescue packages wouldn't be available if Cyprus left the euro, but these rescue packages come with many strings attached and are a distinctly mixed blessing.

The main advantages must be of geo-political nature, as based on pure economics, we see few advantages and many large disadvantages. Perhaps Cyprus doesn't want to risk drifting from the EU into the influence sphere of Russia. But the price for that is economic suicide, creating a lost generation like that of Spain and Greece.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.