Cyprus's future: Is euro membership viable?

By Laurence Knight
Business reporter, BBC News

image captionWhere to next for the Cypriot people after the crumbling of the country's financial services sector?

Thinking about the future is hard for many of those struggling with the crisis in Cyprus - yet it is essential to consider how an economic recovery could be engineered, and whether this would be best done within or outside the eurozone.

If some sectors of the Cypriot economy - finance, construction, real estate, retailing - must inevitably shrink, what other parts could take up the slack?

Tourism is one obvious candidate, and a handy export earner for a country that in 2012 collectively spent more than 6% more than it earned. The sector already accounts for about a sixth of the economy.

Manufacturing may also have potential, although it would be starting from a much lower base - only 6% of GDP - and has been shrinking up until now.

Manufacturers also typically rely on the ability to import parts - something that may prove impossible for local companies so long as international capital controls stay in place and the banking system remains dysfunctional.

Unfortunately, both these sectors also face another common enemy: the euro.

Cypriot labour costs rose 40% between 1995 and 2008, making it a relatively more expensive place to go on holiday or locate a widget factory, and the main reason why Cyprus has been collectively spending more than it earns.

But as long as it remains in the single currency, Cyprus - like the rest of southern Europe - cannot gain a cheap international price advantage by devaluing its currency.

That puts it at a permanent disadvantage as a holiday destination to nearby Turkey, for example.

Hard budget constraint

Another drawback of being in the euro is that you do not control your own central bank.

Whereas the UK and US governments can rely on their central banks to buy up a lot of their debts through their quantitative easing programmes, the countries in the eurozone face much harder budget constraints.

Cyprus - like all other governments seeking a bailout - has been told to impose spending cuts and tax rises.

As the IMF recently pointed out, imposing austerity in the middle of an economic depression - an increasingly common practice throughout the industrialised world since 2008 - has turned out to be much more damaging for those countries' economies than policymakers (though not many economists) had anticipated.

Cyprus is expected to carry out "fiscal consolidation" equivalent to 4.5% of GDP, which the IMF study suggests is likely to shrink its economy by even more than that percentage.

Even so, the Cypriot government's debts are still expected by the EU to pile up, peaking at 140% of GDP, a level that many consider both optimistic and unsustainable.

All of this is fairly rotten for a government that - like the Spanish and Irish - actually had modest and falling debts before 2008.

Nuclear option

The country's rescue lenders may, of course, relent in their demands.

Cyprus is only the smallest of many countries to find itself stuck between the rock of bank deleveraging and the hard place of government austerity.

Spain, Italy, Ireland, Greece and, increasingly, France are all experiencing the ugly consequences for their economies. So it could be that Germany soon finds itself in a minority over its demands for more spending cuts.

Cyprus does, of course, have some say over its destiny - it could still choose the nuclear option of leaving the euro.

Any expectation that Cyprus would leave would result in bank runs, capital controls and huge losses for depositors. Who wants their deposits forcibly converted into a new Cypriot currency and then devalued?

But, given that Cyprus already faces all the above, some economists are asking why not just go ahead and leave?

At least that way it can enjoy the benefits of devaluing and of regaining a central bank that is able to finance the government directly.

The Cypriot public have seemingly turned against the euro - and the popularity of the single currency is on the wane generally across Europe.

Indeed, it could be that if Cyprus does end up leaving, it is because depositors anticipate the decision before the government has even made it.

To put it another way, if the Cypriot public want out of the euro, who on earth would opt to keep their money in a Cypriot bank account, even if it is backed by the European Central Bank?

This is the second in a two-part series on the future of the Cypriot economy. The first looks at how to restore confidence in the country's banking system.