Cyprus: Slump Squared?

by Andrew Stuttaford

Frances Coppola (not the director) ponders the implications for Cyprus of a sudden and brutal contraction of its financial sector, something that may well be on the cards:

 The effect of large and small depositors removing funds on that scale will be a brutal economic downturn as the money supply collapses. In particular, the dominant financial sector will suffer a severe contraction, putting thousands of jobs at risk and paralysing lending to Cypriot households and businesses. And that is IN ADDITION to the estimated 4.5% economic contraction that is already happening due to austerity measures imposed on Cyprus in 2012 to reduce its fiscal deficit, and the further measures required in this bailout. “Deep recession” is already forecast for Cyprus. A major bank run will be economically catastrophic. And the effect of that economic disaster will be to increase both the fiscal deficit and the public debt as a proportion of GDP. After all, even if the government doesn’t increase borrowing, a collapse in GDP immediately raises the debt burden to unsustainable proportions, spooking investors and causing unaffordable rises in yields on sovereign debt.

Cypriot banks may or may not become insolvent. They will become completely dependent on central bank funding, of course, just like their Greek counterparts. But a second bank bailout is not a complete certainty. What in my view is a racing certainty is a SOVEREIGN bailout [the current bailout is a bank bailout, although that is a distinction largely without a difference] due to GDP collapse some time in the next two years.

Well, just so long as it’s after the German election . . .