Why it makes sense for Cyprus to leave the euro

Life is a great leveller. The Russians thought they had found an easy way to launder money by simply moving it to banks in Cyprus.

The Cypriot banks thought they had found an easy way to make more money on that money by investing it in Greece.

Trouble started once the Greeks decided that the borrowed money was as good as their own, and did not have to be returned. This left the Cypriot banks reeling with big holes in their balance-sheets. They were too big to be rescued by the Cypriot government. Hence, they needed to be bailed out by an institution which was bigger than their own government.

[caption id=“attachment_681512” align=“alignleft” width=“380”] A plan was made to forfeit a part of the deposits lying in Cyprian banks. AP[/caption]

The International Monetary Fund(IMF) and the European Union(EU) moved in together and agreed to hand over 10 billion (or around $13billion) to the Cyprus government.

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But there was the risk of the Cypriot government also deciding to behave like the Greeks had before them, and treat the 10 billion bailout as their own money. So, the IMF and the EU demanded some sacrifices to be made by Cyprus as well.

A plan was made to forfeit a part of the deposits lying in Cyprian banks. A levy of 6.75 percent was proposed on deposits of less than 100,000 and 9.9 percent on deposits above that. Of course this did not go down well with the people of the country and they protested. So did its Parliament.

The plan was modified. And it was decided that the government will seize deposits greater than 100,000 lying in the Popular Bank of Cyprus (better known as Laiki Bank), the second largest bank in the country.

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This move was accepted by Cyprus because deposits greater than 100,000 were largely held by the Russians. As The Huffington Post wrote “The country of about 800,000 people has a banking sector eight times larger than its gross domestic product, with nearly a third of the roughly 68 billion euros in the country’s banks believed to be held by Russians.” Hence, the move of seizing deposits greater than 100,000 did not impact citizens of Cyprus in a direct way. It ended up screwing the Russians. As I said at the beginning life is a great leveller.

But that does not mean that Cyprus would not have to bear any cost of such a move. Cyprus had positioned itself as a tax haven to attract money from all over the world. And with the government moving to seize deposits greater than 100,000, it has lost its core industry of banking. Russians and other investors across the world who used Cypriot banks to launder money will think twice before moving any money into the country. They will also move out the money they have in the country, once the capital controls are relaxed. As Ambrose Evans-Pritchard writes in The Telegraph, “The country has just lost its core industry, a banking system with assets equal to eight times GDP, and has little to replace it with.”

With its core industry gone, its economy is bound to slow down in the days to come. The financial sector makes up for around 18 percent of the country’s GDP. “I wouldn’t be surprised to see a 20 percent all in real GDP,” Noble Prize winning economist Paul Krugman told Pritchard.

There are other estimates of the Cypriot economy slowdown which are equally scary. As Matthew O’ Brien writes in The Atlantic, “the International Institute of Finance thinks Cypriot real GDP could fall as much as 20 percent over the next few years…And remember, unemployment is already 14.7 percent n Cyprus. It could easily climb to 25 percent.”

To cut a long story short, Cyprus is going to be in worse shape than it was in the past. So what is the way out for the country? It needs something to replace its banking and financial sector. The manufacturing sector forms just 7 percent of its GDP.

Tourism is the other big employer in Cyprus. But since Cyprus moved on to the euro as its currency, on 1 January 2008, tourism has become very expensive. “Cyprus cannot hope to claw its way back to viability with a tourist boom because EMU (Economic and monetary union of the European union) membership has made it shockingly expensive. Turkey, Croatia or Egypt are all much cheaper….The IMF says the labour cost index has risen even faster than in Greece, Spain or Italy since the late 1990s,” writes Pritchard.

In the past, countries which ended up in such a mess have devalued their currencies and exported their way out of trouble. When a country devalues its currency its exports become more competitive. Let me explain this in an Indian context. Let us say an Indian exporter exports a certain good at a price of $100 per unit. When one dollar is worth Rs 50, he gets Rs 5,000 per unit. If the rupee falls to Rs 60 per dollar, the exporter gets Rs 6,000 per unit. So the exporter makes more money.

What the exporter can also do is cut his price in dollar terms. If he cuts his price to $90, he will end up with Rs 5,400 ($90 x 60), which is greater than the Rs 5,000 he was making in the past. At a lower price, his goods will become more competitive in the international market and thus he will be able to sell more.

Iceland is a very good example of the same. A country of 300,000 people which went financially bust a few years back has been able to get its exports going at some level because its currency, the Icelandic krona, fell in value against the other currencies. “What saved Iceland from mass unemployment after its banks blew up was a currency devaluation that brought industries back from the dead. Iceland’s krona has fallen low enough to make it worthwhile growing tomatoes for sale in greenhouses near the Arctic Circle,” writes Pritchard.

But Cyprus cannot do that given that it does not have a currency of its own. It is a part of a monetary union and the euro is used as a currency by 16 other nations . Cyprus can only devalue its way out of trouble if it chooses to move out of the euro and go back to the Cypriot pound, which was its currency before it decided to move to the euro.

As O’Brien puts it, “The euro isn’t terribly popular in Cyprus right now. Only 48 percent of Cypriots were in favour of the common currency last November…compared to 67 percent of Irish, 65 percent of Greeks, 63 percent of Spaniards, and 57 percent of Italians. The euro is actually less popular in Cyprus than anywhere else in the eurozone-and it’s only going to get less so as their economy disintegrates.”

It makes great sense for Cyprus to leave the euro in the hope of getting its export going. Moving back to the Cypriot pound will also get its tourism sector up and running again. Let me explain this by extending the example used above. A tourist looking to visit India is more likely to come when one dollar is worth Rs 60, than when its worth Rs 50. At Rs 60 to a dollar, the tourist can consume goods and services worth Rs 6,000 in India, whereas at Rs 50 his consumption will be limited to Rs 5,000. The same logic works for Cyprus as well if the country decides to leave the euro and move back to the Cypriot pound and devalue the pound against international currencies.

One fear that has constantly been raised about leaving the euro is this: once people realise there is a real prospect of a country leaving the euro and moving on to its own currency, they will rapidly pull out money from the country. This argument works to some extent. In the case of Cyprus though, international investors who have put their money in the country will pull out (and have already pulled out) their money irrespective of whether the country remains in the euro or not. As O’ Brien puts it, “Countries can’t leave the euro because its banks would collapse and there would be massive capital flight, and … wait. These things_have already happened in Cyprus_. Its banks just got restructured, and it just instituted capital controls. There’s not much left to lose from euro-exit. And plenty to gain.”

The danger of Cypriots moving out their savings is not very strong. As Albert Edwards of Societe Generale writes in his recent report titled The eurozone is working just fine - as far as Germany is concerned: “I know from first-hand experience the extreme difficulty for a European citizen to open an account in another European country; it is nigh on impossible for the man in the street.” Given this its highly unlikely that people of Cyprus will be able to move their money out of the country. But that is no guarantee that money will continue to remain in Cypriot banks. As Edwards put it, people have the “choice of stuffing” their “money under the mattress or buying safe financial assets (maybe overseas mutual funds or gold?), or indeed spending the money on goods and services.” (For a more detailed argument on how a country should move out of the euro in a somewhat orderly manner click here ).

If Cyprus does decide to leave the euro, it might encourage other countries to do so as well. There are several countries which could face a Cyprus type of bailout in the days to come. As Guy Verhoftstadt, a former PM of Belgium writes in The New York Times: “Perhaps Malta, which has an even bigger banking sector than Cyprus relative to GDP, much of it highly reliant on offshore depositors. Or maybe Latvia, fast becoming the destination of choice for Russian funds flowing out of Cyprus and now on course to join the eurozone. Even Spain or Italy could be vulnerable to a similar bailout, now that the Dutch finance minister, Jeroen Dijsselbloem, who is President of the Euro Group of finance ministers, has hinted that Cyprus could provide a model for the resolution of future banking crises.”

Given this, the future of the euro looks very dicey. As Martin Wolf, one of the foremost economic commentators of the world, wrote in a recent column in the Financial Times “Old fears that the euro would undermine European unity rather than strengthen it seem more plausible.” Nobody could have put it better.

Vivek Kaul is a writer. He tweets @kaul_vivek