Cyprus’s economy—how will it recover?

Even with capital controls in place to stifle the immediate collapse of the Cypriot economy, the prognosis for recovery within the euro currency is grim. A respected fund manager and strategist who tweets as @Pawelmorski compares the impact of the negotiations in Cyprus to a full-on war (our emphasis):

Take a moment to realise the scale of what’s been done here. No human agency has acheived so much economic destruction in such a short time without the use of weapons. The combination of laying waste to the financial sector and tearing up the savings of thousands of residents means that Cyprus won’t return to current levels of output for a decade, a funeral pyre which bears comparison only with Greece. There are four shocks happening at once; the bog-standard austerity shock; the trauma of bank withdrawal controls; the wealth shock; and the structural shock of wiping out the financial sector.

The Economist’s Charlemagne blog wonders where growth may even come from, perhaps some day in the distant future, if Cyprus’s financial sector has been wiped out:

Some sources in the troika tentatively estimate that GDP will shrink by about 10% before any hope of recovery. Perhaps the biggest question is this: once the banks have been cleaned up and shrunk, where will Cyprus find economic growth? The promise of offshore gas deposits is still too uncertain, and tourism may well decline if Russians suddenly find the island to be less hospitable to their money.

The rest of the euro zone—knock-on effects

We’ve argued before that this wasn’t a “good” outcome for the euro zone. Other commentators seem to agree with us that damage has been done in the last week to euro leaders’ credibility, their relationship to the IMF, and the shaky standing of other countries in the euro area.

In a report published late yesterday (March 24), Moody’s ratings agency warned that poor handling of negotiations with Cyprus “increases the likelihood of high-severity tail risks“ (pdf, registration required):

The hard line adopted by euro area governments during negotiations suggests it is more willing than in earlier stages of the crisis to tolerate a risk of inducing financial market disruption when imposing conditions – a willingness designed in part to appease domestic political pressures, particularly in Germany.

It would appear that EU policymakers have so far failed to recognize this, even commenting at press conferences early today that the market clearly hadn’t reacted poorly to the situation. FT Alphaville’s Joseph Cotterill noted that, despite the drama of negotiations, EU leaders seemed happy to have subjected Cyprus to years of hardship:

Incidentally, there was no sign of contrition at the Eurogroup presser about the grievous mistakes of the first deal. If anything, they were all rather smug about how clever the new arrangement was: “we deal with the problems where they have arisen,” Dijsselbloem said.

From an investment perspective, however, it’s hard to look at Cyprus, Greece, and a handful of other EU financial institutions and not decide to move your money to a safer place, says Peter Tchir, founder of TF Market Advisors, in a client note. En masse, this kind of behavior could produce bank runs or slow flows of capital from the periphery to the European core, exacerbating the “two-tier” Europe that has emerged since the crisis took hold:

You are now relying on other companies [to be] either brazen risk takers, completely stupid, or just lazy when it comes to why any company or individual would have deposits greater than €100,000 at any bank in Greece or in Bankia at very least, and possibly in the entire PIIGS universe.  For all the “Russian Oligarch” talk, there was no distinction about large deposits, and even if there was, why wouldn’t the next time include “subsidized banker gains” or something.

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