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Cyprus faces an economic catastrophe even worse than that inflicted on Greece

Cyprus faces an economic catastrophe even worse than that inflicted on Greece Shaun Richards

The last fortnight has seen some extraordinary developments in the Mediterranean island of Cyprus. These have seen a small island become a problem for the euro project that is way out of kilter with its 0.2% share of its overall economic output. Also we see something that has developed relatively quickly as the Greek part of Cyprus only joined the euro on the 1st of January 2008. Oh how they must rue statements like this from back then.

Furthermore, for a small open economy such as Cyprus, the euro adoption provides protection against international financial turmoil, which often has a disproportionate effect on smaller economies.

This was made by the President of the European Central Bank Jean-Claude Trichet in Nicosia and he went onto demonstrate that moving to fortune-telling would be an unwise career choice for him.

Cyprus has not experienced major imbalances

Indeed even the friendly welcome below now has to be reviewed in the light of the euro area's cold and frosty response to the problems ahead.

Warmest welcome Cyprus!

Actually Cyprus was experiencing an imbalance

What was in the process of occurring was that Cyprus was becoming a major offshore banking sector particularly for Russian money but it is also true that UK money went there. If we ask why we see several reasons of which the main factors are the fact that Cyprus has low taxation rates and her banks offered attractive interest-rates. An example of the lower tax rates is that foreign pension incomes were only taxed at a rate of 5% which meant that a large pensioner expatriate community grew up with ex-UK residents to the fore. Another is that contrary to many claims that Ireland had the lowest corporation tax rate in the euro area it was in fact Cyprus at a rate of 10%.

An example of the interest-rates available can still be found online as the Cypriot part of the Greek Piraeus Bank was still as recently as February offering an annual interest rate of 4.7% on for fixed-term savings of six months. Perhaps caveat emptor should always have applied as this is some 4% over the official ECB interest rate but money was attracted as the sales pitch told them this.

No risk like in stocks

Stable and fixed return on the invested money

Of course neither statement has proved to be fully true.

So what happens now?

As banking boom has followed its by now common rout to banking bust we see that the bust of a banking sector some seven times larger than the underlying economy is a crippling blow for Cyprus. So she had to call for help from her colleagues in the euro project although there is the issue that their "help" is currently contributing to the collapse of the Greek and Portuguese economies.

Cyprus feels the pain

In return for a bailout package of some ten billion euros, Cyprus has had to find at least 5.8 billion from its own resources. After initially concocting a plan to take funds from all bank deposits and savings they have now settled on one which will only take funds not guaranteed by her deposit scheme at her two largest banks.So depending on your perspective bank deposits over 100,000 euros there will be subject to a contribution, deduction, penalty, tax or theft! The size of this is still unclear as 30% was suggested but if you start to run through the numbers that seems to leave them short of the required amount.

Capital Controls

An interesting paragraph heading for a single currency don't you think? If you are asking yourself how does that work then you have my sympathy? Going forwards a Cypriot euro will clearly have a lower value than that for a German,Italian or French one. These differences can be large as for example Iceland which has capital controls has a difference of the order of 20% between its official and unofficial or black market exchange rate. Also they can go on and on as they have existed there since November with no sign of them being lifted in spite of the original promises about them being temporary.

Unfortunately any real detail on the proposed capital controls is missing as I type this post. We have some leaks such as they are proposed to last seven days and that restrictions will involve being only able to spend 5000 Euros a month on a credit card and that on a foreign trip only 3000 euros will be allowed per person in cash. Frankly the seven-day term is an utter fantasy in my view as after that period nothing will have changed!

Comment


So if we look at the Cypriot economy we have all the pieces in place for quite a savage reverse in it. For example her money supply is about to have a sharp contraction via official policy and unofficial capital flight. There must also have been a considerable interruption to many businesses over the past fortnight. We also know that the eurocrats will apply their austerity medicine which has had a calamitous effect on the economies it has been applied to so far. But perhaps the most powerful force will be psychology as in the confused and uncertain environment who will want to start a new business or expand an existing one?

Tags: Cyprus , euro , euro crisis , Europe , eurozone , Greece
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  1. patricka says:
    Wed Apr 03 14:13:26 BST 2013

    This all seems quite dreadful for the ordinary Cypriot. That quote from the head of the European Central Bank makes him look an utter fool. The best thing that Cyprus could do now is get out of the Euro.

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