Cyprus and the eurozone: crisis? what crisis?

by George Hatjoullis

Golden Dawn

Golden Dawn (Photo credit: unNickrMe)

Global financial markets have opened this morning after the long (Catholic) easter weekend with no evidence of a pending financial crisis. The price action is quite consistent with local events and the usual ebb and flow of markets. This should come as no surprise. Cyprus is a small economy with a banking system that is of no systemic consequences for the eurozone. The callous and brutal treatment of the Greek Cypriots is not going to be repeated throughout the eurozone. If it is then maybe a crisis will emerge. All eyes on the treatment of Slovenia.

The reason Cyprus has been so treated (and Greece before) has been elucidated in an earlier post. The troika judged that moral hazard is particularly high in the case of Cyprus and that some seriously tough love is required. Of course, the troika are practical (if heartless) and would have offered softer terms if they had felt Cyprus had systemic significance. In short, Cyprus was crushed because they could. However, there is one element of this calculation that may yet backfire and make Cyprus systemic; a Cyprus exit from the eurozone.. This remains a high risk. The reason is that the financial package and the clumsy way if has been managed both by the troika and the incoming Cyprus administration has inflicted incalculable damage to the economy of the Republic of Cyprus.

A unnamed official is reported in today’s Guardian ( as suggesting RoC GDP will fall by 9% in 2013. The outlook for the RoC economy has been touched on in an earlier blog but suffice it to say this looks a touch optimistic. More important, the pace of recovery may be longer and more laboured than most estimates suggest. The RoC administration is asking for more time but i doubt that it will get enough time. The ten billion euro ‘rescue’ package will not be enough and Cyprus will have to be rescued again. This makes a mockery of the IMF assertion that all this destruction was necessary to ensure a sustainable debt path. The package clearly does no such thing. The economic consequences of the package for the RoC are so severe that exit involves little extra hardship and in providing a further degree of freedom, currency depreciation, offers a glimmer of hope.

A Cyprus exit thus remains a significant risk. Does this have existential significance to the eurozone? The eurozone is built on the idea that membership is irrevocable. The exit of a member, however insignificant, blows this important idea away. It could be like pulling on a loose thread on wool jumper. It may unravel the whole project. The matter is made even more concerning because exit from the eurozone may, paradoxically, necessitate the exit from the EU. I refer readers to this paper from the ECB which i have not yet seen superseded ( The following quote has always struck me as important, “…a Member States exit from EMU, without a parallel withdrawal from the EU, would be legally inconceivable”. A Cyprus exit could thus open Pandora‘s box of spirits.

The IMF/Berlin driven austerity approach to sovereign debt and bank crisis resolution has devastated the eurozone economy. Unemployment rates are high and rising and economic activity is struggling to lift its aggregate head. Today’s eurozone purchasing manager index outcomes are testament to this. Credit growth remains largely absent without leave. However, the ECB remains reluctant to reduce the repo rate because it believes it to be rendered redundant given the fractured nature of the eurozone economy. It was the crisis resolution mechanism adopted that fractured the economy. The remarkable thing about all this is how little domestic social unrest individual member states have experienced. After an initial outburst, the domestic populations seem resigned to their respective fates. In Cyprus there has not yet even been an initial outburst. However, if things do not improve soon,and they will not, then some further emphatic protests are to be expected. Moreover, the ballot box is going to be an uncomfortable place for the eurozone’s elite.