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End of an era

26 June 2012 By Neil Unmack

Hit by a perfect storm of economic slump and man-made disasters, Cyprus has been forced to seek euro zone help. Though implementing reform could be controversial, the 10 billion euro rescue is peanuts for the zone’s bailout funds. Europe will need a different strategy to cope with Spain and Italy.

The Cypriot economy has been hit by the euro zone crisis and rising unemployment. It has also suffered two separate catastrophes; an explosion at the main electricity plant which generated half the island’s electricity, and Greece’s debt restructuring, which left Cypriot banks with severe losses on their holdings of Greek government bonds. Despite being locked out of markets since mid 2011, Cyprus has got by borrowing from Russia.

Cyprus will probably need about 10 billon euros, equivalent to roughly 55 percent of GDP. Deutsche Bank reckons it needs 4.2 billion euros to cope with banks’ losses on Greek bonds and loan write downs, and a further 6.3 billion euros to fund deficits and maturing debt until 2015. In this scenario, debt would peak at about 99 percent of GDP in 2013. But that would be optimistic if Greece left the euro; bank loans to the Greek economy total just shy of 120 percent of Cypriot GDP.

Though the euro zone is getting used to bailing out its members, Cyprus won’t be easy. The country will need to tackle a lingering competitiveness problem, evidenced by persistent current account deficits, forecast at 7.8 percent of GDP this year. The government is implementing a diet of austerity and wage freezes, but euro zone paymasters may be tougher, and will also want a crackdown on tax-collecting inefficiencies and evasion. The risk is that reforms get bogged down by presidential elections next year.

Luckily, the size is small. The euro zone’s bailout funds can easily finance Cyprus from their existing resources, and there is no immediate need for a Greek-style private sector debt haircut. Yet the Cypriot bailout marks the end of an era for the euro zone. It has bailed out four relatively small countries, and is now rescuing Spain’s banks. The next problems are Spain and Italy. With 526 billion euros of debt maturing over the next two years, they are far too big for the Cyprus treatment.


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