Economic consequences of a Cyprus Euro exit
Obvious strategic reasons dictate that Cyprus should wait-it-out and stay in the Eurozone. An exit from the Euro and return to the pound amounts to strategic suicide. It will leave Cyprus alone and vulnerable, without friends, at the mercy of Turkey. It will amplify both geopolitical and economic risks for Cyprus at the present very unstable juncture.
On purely economic grounds, suggestions for Cyprus’s exit from the Euro (the latest by Krugman) are misguided. The main argument is that return to the local currency (the Cyprus pound) would allow devaluation, and presumably allow the country to become more competitive globally. This might be a valid argument if the effected economy is primarily driven by exports. In that case, local goods and services (e.g., tourism) might become relatively cheaper compared to global alternatives and enable the nation, theory goes, to gradually climb up into competitiveness and economic recovery.
But Cyprus’s economy is primarily driven by imports and suffers from severe structural inefficiencies that make it unlikely to return to competitiveness from a mere currency switch. A 30% devaluation, for example, would mean that salaries and wealth in (local currency) would be roughly 30% lower. But the cost of all sorts of imported goods, from petrol and gas, to pharmaceuticals, all the way to shoes and clothes, would go up as they would still need to be paid in Euro or other international currencies. In the midst of an ongoing economic contraction and dangerous loss of confidence, leaving the Euro and the prolonged uncertainty at all levels it would create would have severe adverse consequences on consumption, savings, investment and growth. Moreover, defaulting on Cyprus’ debt (denominated in Euro) will severely damage its credibility, economic and political relations with the EU, damage trade for decades and lock out Cyprus from international markets even in case of proven gas discoveries.
Would Cyprus’s national competitiveness in the global arena go up to offset this additional loss of real income, wealth, credibility and growth prospects? This is a most doubtful and shaky proposition. Cyprus’ financial and related professional services sector has been dealt a deadly blow regardless. A lot of export services linked to banking and off shore business have taken a big hit. The financial sector will not likely recover simply by switching from an international currency to a tiny, local currency. Even a more than 30% reduction in professional services costs would not entice the Russian or other international businesses to hang around. And the extra costs of conversion from the pound to an international currency would not help. Neither would the loss of confidence.
How is the tourism sector going to fair out? Is a cheaper Cyprus pound going to attract enough international tourists to Aphrodite’s shores to make up for the loss of wealth? This is not likely to be the case. Cyprus hotels face large energy bills, labor costs, loans (in Euro), and deteriorating facilities. A 30% shadow price drop is not enough. Quality of service is lacking relative to nearby alternative destinations, such as Egypt, Turkey or Dubai, and price packages are still not competitive (even at 30% lower prices). Especially when tourists realize that they may have to pay as much for taking a taxi within Cyprus as was the cost of the airfare to fly there. The cost of a taxi in Egypt and Turkey is much lower. Taxis are owned by the state in Dubai and the costs are strictly regulated and among the lowest in the world. If the (low-paid) Pakistani taxi driver attempts to cheat a tourist, he is thrown out of the country.
Cyprus’s semi-governmental agencies, such as the electricity authority, are grossly inefficient operations that make positive excess profits on the back of Cyprus’s consumers and businesses. Employees are paid allowances for driving the car to work and enjoy an automatic lunch allowance. Employees are paid significant salaries (plus the above allowances) for cutting tree branches above the electric poles that could be outsourced to professional gardening services at a fraction of the cost. They have enjoyed interest-free loans to send their children to college. As a result, a household pays €300-400 in electricity bills rather than €100. Not only they charge for electricity 3-4 times more than what should be in a global competitive environment, indirectly taxing the poorest layers of Cyprus society, but they contribute to ensuring that Cyprus’s tourism and other industries remain globally uncompetitive. All the political parties in Cyprus are against privatization. Effectively, this is the same as being in favor of exploitation of the people by these agencies and pulling down the long-term competitiveness of the country. How can families, hotels and businesses survive with such high electricity prices? In the name of protecting future generations, politicians are keeping local monopolies in place while digging the grave of national competitiveness, whether within or outside the Euro.
No financial gimmicks, like switching currency, will solve any real budgetary or competitiveness problems for Cyprus. There are no such magic solutions in real-world economics.
Structural inefficiencies in Cyprus’s economy should be rooted out, not preserved through easy sounding round-about solutions like exiting the Euro. Much structural change involving privatization of semi-public entities, governmental institutions and services and banks is needed. These structural improvements would not take place without the political pressure (and guidance) of the troika. It would actually be desirable if the troika extends its reach beyond the Central Bank and into the headquarters of all Cypriot political parties. A lot of restructuring and cleaning up is needed.
The above presumed benefit of 30% currency devaluation and improved competitiveness from exiting the Euro and switching to the pound could simply be achieved more directly. Cypriots could simply voluntarily accept a 30% cut on public employee payroll (the private sector will voluntarily adjust) and drop tourism services prices (including taxis) by 30%. Those prices could come down as effectively as devaluing, and better to do it once by opening up various protected semi-governmental agencies (e.g., the electricity authority, telecom) or closed professions (e.g., taxis, pharmacists etc.) to competition rather than rely on devaluations every 10 years. For example, if the taxi association does not agree to voluntarily drop prices by 30% as a contribution to national competitiveness, it is not hard for the state to regulate that a taxi service from Nicosia to Larnaca airport should be 30 (rather than 45 or 50) Euro. After two complaints by tourists, the license is revoked. Further, there is no economic reason why a bank, pharmacy or a university secretary should not work on Wednesday afternoon. The government or the troika should look into these areas as well if certain professions cannot constrain themselves. Structural reform is needed to enhance long-term competitiveness no matter what monetary options are followed.
The above internal measures could replicate, more cheaply, the main purported benefit of exiting the euro, while avoiding its many drawbacks. The more serious drawback from exiting the Euro is self-cancellation of European insurance policy offered to Cyprus from being part of the Eurozone against potential future machinations by Turkey.
Cyprus should play the game it voluntarily entered (by inviting the troika) until the end, or at least play another couple of rounds and see. Perhaps after the elections in Germany and some luck with evaluation drilling results in June, with some deeper strategic thinking by its leaders after recent experiences, it might be able to persuade EU leaders that maybe they have overdone it with Cyprus and that their long-term strategic energy interests lie with keeping Cyprus’s economy and its gas prospects alive and kicking as an alternative to Moscow’s energy chocking.
Perhaps the timeframe in the last weeks was extremely narrow and the pressures too intense on everyone for thoughtful strategic decisions. Greece was under the gun of the Troika with a deep liquidity crisis of its own and 300 suicides. Israel has been under clear pressure from the US to coordinate with Turkey on Syria. Perhaps Russia had to reflect on a set of conflicting interests regarding Cyprus and may simply have found it easier to just wait-it-out. Potential strategic alliances for Cyprus have been dealt a blow but perhaps might be resurrected with determined, clear and smart strategic thinking by Cypriots. Staying in the Euro might buy time to enable strategic rethinking and regrouping strategies. If Cyprus is able to stabilize its economic problem within the Eurozone, it will gain time to test the limits of key players such as Russia and Israel. Perhaps Israel and the EU leadership, after the German elections, might reconsider the possibility of a permanent dependence on a Turkish pipeline or of continued monopolistic dependence on Russian gas. Economics, politics and strategy are intertwined.
Regardless of the path chosen, Cyprus requires internal reforms which will make its public sector and its economy more flexible and globally competitive.
Lenos Trigeorgis holds a PhD (DBA) from Harvard University and is the Bank of Cyprus Chair Professor of Finance at the University of Cyprus and President of the Real Options Group. He has been a Visiting Professor of Finance at the London Business School. He is the author of Real Options (MIT Press, 1996), Strategic Investment (Princeton University Press, 2004) and Competitive Strategy (MIT Press, 2011).