Effect of Cyprus exit from Euro seen as limited

Forget about a Grexit. What about a Cyprexit? A Cyprus exit from the euro union, if it comes to that, would have a devastating effect on the country’s citizens, who are among the most indebted in the euro zone.

And for European unityand diplomacy, the Cyprus debacle has already been at least a short-term disaster.

For the broader financial system in Europe, however, the losses resulting from a Cypriot banking collapse and the country’s return to its former currency would be minimal compared with the havoc that Greece would have created had it not been bailed out.

That, economists and investors contend, is precisely why Germany and its Dutch stalking horse, Jeroen Dijsselbloem, the president of the Eurogroup of Finance Ministers, were so adamant that depositors – large and small, Cypriot and Russian – contribute 5.8 billion euros, or $7.5 billion, toward the 10 billion-euro bailout of Cyprus’ largest banks.

Greece may well have been too big to fail last year, but Cyprus, which creates less than one-half per cent of the euro zone’s gross domestic product, is certainly not.

From a financial standpoint, what is most noteworthy is that the combined debt of the Cypriot people, companies and government is 2.6 times the size of the country’s gross domestic product. Only Ireland, which is still struggling to recover from the banking collapse that required an international bailout in 2010, has a higher debt-to-GDP ratio among euro zone countries.

As debts in Europe mount in inverse proportion to the ability of its citizens, companies and governments to make good on them, the view is forming in Berlin and Brussels that – especially after the latest Greek rescue – a signal must be sent that, for the eurozone to survive in the long run, citizens and investors must start accepting losses.

“There have been too many bailouts in Europe; it’s time to remove the air bags,” said Stephen Jen, a former economist at the International Monetary Fund who runs a hedge fund in London. “This is not a Lehman,” he said, referring to the disastrous chain reaction touched off by the collapse of Lehman Brothers in 2008.

With Cyprus, “the links are psychological, not mechanical,” Jen said. “In Greece, the links were both mechanical and psychological.”

Eric Dor is a French economist who has studied the mechanics of how a country might remove itself from the monetary union. By his calculations, the euro zone – through its central banking system and its national banks – has just 27 billion euros in outstanding credit exposure to Cyprus. That is a mere rounding error compared with the eurozone GDP of 9.4 trillion euros.

Estimates of the potential cost if Greece had been forced into a disorderly euro exit have ranged from 200 billion to 800 billion euros, given the larger exposure that the European Central Bank and European banks had to the country.

“This explains why Germany and others are putting so much pressure on Cyprus,” said Dor, head of research at the Leseg School of Management in Lille, France. “They are saying we can take the risk of pushing Cyprus out of the euro zone, and that Europe can take the losses without going broke.” So when the president of Cyprus admitted recently that his country did not have the funds to backstop the 30 billion euros of guaranteed bank deposits – a figure greater than the Cypriot economy itself – a crucial bond of trust between a government and its citizens was snapped.

A hasty expulsion from the euro zone would make the savings of the Cypriot people all the more evanescent, once they are converted back into Cypriot pounds, the currency Cyprus used before adopting the euro in 2007. Analysts project that the de facto devaluation would be not only immediate – estimates range from 30 per cent to 40 per cent – but extremely punitive, given the high household and corporate debts that burden Cypriots.

That means that in addition to Cyprus’ defaulting on its debts, many individuals and small businesses, the backbone of the country’s economy, would go bankrupt and the country would face a depression that could rival Greece’s in its severity.

“You would see genuine poverty in a euro area country,” said Gabriel Sterne, an analyst at Exotix, a London-based investment bank that specialises in distressed debt. Nevertheless, the anger and frustration among Cypriots toward Berlin and Brussels is such that in a recent poll 91 per cent of respondents said they would rather leave the European Union than submit to the deposit taxes demanded of them.

Suddenly, just six years after having adopted the euro, economists in Nicosia are dusting off their currency-assessment models to better understand what the immediate economic effect might be if the Cypriot pound were to be reintroduced. The price of imported oil in particular would soar, with profound economic impact because oil is used to produce electricity that already costs more than almost anywhere else in Europe, according to Alexandros Apostolides, a local economist who is engaged in just such a study.