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21 March 2013

Crisis In Cyprus - The Options

After Cypriot lawmakers rejected the ECB bailout, there is much speculation as to what will happen next. The official response from the Eurozone (Eurogroup) is that they have “noted” the rejection. The bank reopening that was to occur on Tuesday, but then delayed until Thursday has now been extended indefinitely. With the closing of banks, the Cyprus Stock Exchange has announced they will close as well.

What are the options for Cyprus?

Get a loan from Russia and stay in the Euro -

Russia has much more vested interest in Cyprus than the EU does. Around 30% of Cyprus bank deposits belong to Russians. This is a sore spot with Euro leaders because they feel that much of any bailout would go directly to Russia. It is also a possible motivation for the deposit tax they demanded.

Russia has no compelling reason to agree to a loan without monumental concessions from Cyprus such as access to their undeveloped offshore gas deposits. Russia has been trying to gain access to these deposits for years, but have been repeatedly thwarted by the EU.

A Cyprus banking collapse would actually be good for Russia as it would shut down a huge tax haven for Russian taxpayers and bring some deposits back to Russia.

Convince the Eurozone leaders to lighten bailout terms -

There are two key elements that might prove to make this option very difficult or impossible. Number one is the feeling among Eurozone finance ministers that the Cyprus banking sector is simply too big, (8 times as big as GDP) and acts as a money laundering enterprise. The ECB is characterizing the Cyprus bailout as a unique, one-time situation that will have no affect on other troubled Euro countries. Cyprus is also a tiny part of the total Eurozone economy, accounting for far less than 1%.

The second reason is more complex; northern Euro countries whose economies are doing well are resistant to further bailouts. The Euro representatives have kept interest rates very low for the benefit of countries like Germany, causing countries like Cyprus and Greece to become more uncompetitive and making economic recovery much more difficult for them.

Exit the Euro and return to the Cyprus Pound

This option would require a deflation of approximately 20-30% along with the significant cost of actually converting the currency and financial instruments. While it would be very difficult in the short term, it would yield several important benefits in the longer term. The country would regain the ability to independently adjust the value of their currency to suit domestic financial conditions instead of being at the mercy of stronger northern EU member states. It would allow them to keep access to the potentially lucrative offshore gas fields. It would give them an opportunity to restructure and further legitimize their banking system

Cyprus exiting the Euro would be bad of course for the Euro’s reputation and might further acerbate the problems in the other weak Euro economies. But behind closed doors, the northern countries may be secretly wishing for a Cypriot exit.