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Should Cyprus and Greece leave the Euro?

Following on from the Greek economic crisis, two years ago, Cyprus’ banking crisis was headline news across the globe, unfortunately for the wrong reasons, writes Loizos Heracleous. The Troika (European Central Bank, European Commission and the IMF) agreed to provide €10bn assistance funds to Cyprus, after an arduous finale to negotiations.

It was decided that depositors in the island’s two largest banks, that had deposits of over €100,000 would have their accounts frozen and thus they could not be withdrawn. This meant losses of almost 100% of their funds above the 100K amount; whilst receiving almost worthless shares which have not reached and likely won’t reach the actual amounts forfeited.

This “haircut” took place because the Troika demanded that Cyprus should contribute €5.8bn itself (later progressively raised to €13bn) to its own rescue package. This amount was small change compared to the EU’s overall budget and to the assistance that had been given to other countries such as Greece by that time (€240bn in two rounds), Spain (€100bn) and Ireland (€85bn). But it was a huge percentage of Cyprus’ GDP, which was €17.7bn in 2012. This train of events was part of the implementation of the debatable austerity agenda. It was swiftly executed and immense in magnitude compared to the size of the country’s economy. Cypriot policymakers were pushed into a corner, and pressured to accept the terms, under pain of economic collapse.

The Cyprus bailout in early 2013 was the first time that the EU required states receiving financial help to make such a sizable contribution themselves (and rejected other means proposed by Cyprus to do so), which led to the appropriation of depositors’ personal funds. It was also the first time that a country using the Euro had to impose currency controls to avoid a mass exodus of funds; and to enable deposited funds to be appropriated. EU and IMF policymakers believed that they finally made financial institutions accept part of the risk and responsibility for their troubles, and paid heed to the frustration of taxpayers of the wealthier EU nations in having to bail out weaker ones.

In the process, the Troika also believed that they made life harder for alleged Russian money-launderers, since about a third of banking deposits in Cyprus were by Russian depositors. Money laundering is a global problem however, and takes place in influential jurisdictions as well as smaller ones; not only via movement of funds, but by investments in assets such as high-end property, by cross-border related party transactions, and by complex corporate structures. To try and downsize a specific country’s banking system in order to address money laundering as was done in Cyprus, is like fighting one’s shadow.

The majority of depositors who were hit were not in fact money launderers (who could in any case easily move their activities around the world) but ordinary Cypriots, small and medium enterprises, and pension funds. Rather than compromising a small country’s banking system, what is needed is a global approach of higher transparency in money movements without impeding legitimate commerce. Cyprus has long adopted global accords to address money laundering and has a relatively low levels of corruption according to Transparency International (ranks 31st out of 174 countries in the 2014 Corruption Perceptions Index, with lower corruption than countries such as Spain, Israel and Italy).

The austerity agenda implemented in both Cyprus and Greece has been questioned by several economists (most notably by Nobel prize winner Paul Krugman), by basic economic principles, and by the dismal historical record of such programs. When at times of economic crisis state fiscal stimulus is significantly cut, the result is even deeper economic problems and most likely recession. No doubt there are structural issues in Cyprus as well as Greece that need to be addressed, including the bloated public sector, lax tax collection and high national debt. But these are issues that can be addressed over time, and ideally at times when economies are robust enough to take reduction in state stimuli, rather than with big bang austerity drives, imposed when economies are at their most vulnerable.

Cyprus contributed 0.2% of the EU’s GDP, and was seen as too small to pose significant systemic risk. Once the appropriation of individuals’ funds took place however, a genie was let out of the bottle. Depositors in other EU countries became more jittery, more likely to rush for the door at the first signs of trouble, which could contribute to the creation of self-fulfilling expectations of financial downward spirals and risk of broader contagion.

The fact is that deposits in the global financial system as a whole cannot be guaranteed, since no bank or nation has the actual funds to do so. This makes the global financial system a confidence trick, the keyword being confidence. Once that is shaken, greater problems arise.

The austerity drive led to a significant GDP contraction in Cyprus of -2.4% in 2012, -5.4% in 2013, and an estimated -2.8% in 2014. Since 2009, Cyprus’ GDP growth has been well below global GDP growth, with the gap widening particularly since 2012. Since adopting the Euro currency in 2008, unemployment in Cyprus rose every single year; from 3.7% in 2008 to 16.1% in 2014. Youth unemployment was 38.9% in 2013 and 35.5% in 2014.

Despite somewhat different internal challenges and trajectory to this position, Greece is in a similar predicament now. The Troika is not budging in its austerity agenda, despite experience from countries such as Cyprus, and its disastrous effects on the Greek economy over the last few years. Since 2001 when Greece adopted the Euro currency, its economy went on a roller coaster, with steep increases in GDP until 2008, followed by equally steep contractions from 2009 till now, which look set to continue if austerity measures are not eased. With youth unemployment of over 50% and total unemployment of over 25%, the social conditions and living standards of ordinary Greeks have become dire, and nationalism has raised its ugly head.

Do Cyprus and Greece need the Euro currency? Cyprus joined the Eurozone in 2004. Its annual GDP growth had been higher during 1980 to 2004, than during 2004-2013, and was particularly low or negative since 2008 when it adopted the Euro currency. There is no reason that its economy could not be strong without being part of the Euro. There is also no reason that, given that Cyprus is a financial centre, foreign currency deposits cannot be held in Cyprus, even if the national currency is not the Euro. The Troika’s insistence that decisions of huge economic and national impact should be taken within a few days, pushed policymakers into a corner, magnified the sense of crisis and posed immense pressure, which led to forcing through a problematic model of assistance with deleterious consequences. This is at risk of happening in Greece.

Given the long-term pain that austerity has brought, a managed exit from the Euro is a real option, which in the medium term may be more beneficial than continued austerity with no end in sight. The way forward is to ease on the austerity measures that have crippled both countries’ economies and to allow higher state spending, in particular to assist vulnerable people, lend to business, and to carry out projects that can inject money in the real economy.

This should be in conjunction with needed structural reforms that can take effect over several years in terms of gradually reducing the size of the pubic sector, increasing labour flexibility, inviting foreign direct investment, improving tax collection, and putting debt under control. A return to a national currency would allow control of key economic levers rather than have to bear the fiscal inflexibility and targets required by a single pan-national currency.

There are many nightmare scenarios that predict hyper-inflation, capital controls and a deterioration of living standards if a country leaves the Euro currency. However these are overblown. No doubt there are costs of exit; a newly introduced and soon devalued drachma in Greece for example would make imports more expensive, raise inflation and increase the cost of debts denominated in foreign currencies. However, business thrives under conditions of confidence and certainty; something sorely lacking in both Cyprus and Greece since the austerity agenda has been implemented, but that could be reversed in the medium term with properly managed exit from the common currency.

After the initial problems of exit, the fiscal stimulus that would accompany a return to the national control of the economy would provide a boost to business, reduce unemployment and help raise GDP. The relatively cheap national currencies would provide a boost to exports, real estate, manufacturing, agriculture, and service sectors such as tourism, legal services and education. Local companies will be able to focus their efforts on their international strategies in order to capitalize on the cheaper national currency. Concurrently, they may become more efficient and productive since they will aim to optimize the use of imported resources that will be more expensive given the devalued currency.

International companies may find the conditions of increased confidence and low domestic costs attractive for initiating foreign direct investment, further enhancing business confidence. These outcomes seem more desirable than continued austerity programmes with no end in sight. is Professor of Strategy at the Warwick Business School.

An abridged version of this article was very recently published by the Harvard Business Review, this can be found at:-

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