Cyprus: The unsustainable trajectory

In Cyprus the choice that has been made is in favor of the Euro Area. It is how we have to interpret the vote on the banking sector restructuration and for the solidarity fund. Today a vote is expected for a tax on deposit above € 100 000.

After the failure of the negotiations with Moscow, this option means that the Cyprus as an off-shore banking sector will rapidly become an old story.

So what is the current situation for Cyprus?

Recent economic developments in Cyprus came from the financial sector. It represents more that 9% of added value. This has to be compared to 5% for the Euro Area on average (see chart 2 on this blog http://frogonomics.wordpress.com/2013/03/21/que-se-passe-t-il-a-chypre/ ). Its role in growth has been important. What will happen with the banking sector restructuration and the end of Cyprus as an off-shore center? That will be negative for growth and for a long time. The current negative shock due to closed banks is one thing the rescaling for smaller of the banking sector will be another negative shock but stronger and with more persistence.

Beside that, with the rescue plan is associated a strategy to rebalance public finance. The € 10bn loan will add up to public debt. So the public debt to GDP ratio will be above 140%. Public deficit was 5.5% in 2012 and 6.3% in 2011). Cyprus will have to reduce its public deficit and stabilize it public debt ratio. We know that with these parameters a sustainable trajectory for debt is almost impossible to attain.

This combination of these two elements is problematic. The banking sector restructuration will imply a drop in economic activity and austerity policy will add up to this change in growth trend.

This trajectory will not be sustainable. The risk is a deep and persistent recession which will feed the anti euro sentiment seen recently in Cyprus.