The Republic of Cyprus (the Greek Cypriot ruled majority of the island) seemed in 2009–at the time when the Greek sovereign debt burst into the international financial scene and set off the wider euro zone crisis–to be a relatively safe haven. Its then successful banking sector continued to thrive helped by deposits from a wide range of foreign investors from Greece itself to Russia. The move over four years from safe haven to country on the edge has been a gradual deterioration rather than the sudden plunge that happened in the case of Greece. However, today, Cyprus is arguably the most problematic country in the euro zone after Greece through the interplay of sovereign debt crisis and banking crisis—the latter resulting partly from contagion from Greece. Recapitalisation by the Cypriot state of Cypriot banks, to make them viable following losses in Greek and other investments, now looks likely to cost €10bn or 55% of Cyprus’s GDP, which combined with ongoing government deficits would push sovereign debt to about 140% of GDP by 2016. This would be substantially higher than in any other euro zone country other than Greece and, according to consensus opinion, by around 20% of GDP higher than the solvency threshold. On the positive side, some of the gap could be closed by privatization which could bring in €2bn and the situation of the country should be also helped by the development of gas reserves, although their extent remains uncertain and they are not a panacea.
Nicos Anastiades, who is likely to be elected as president of Cyprus in the second round on February 27th, faces tough negotiations to secure a bail-out by euro zone partners which would put the state on the path back to solvency and restore confidence in the economy. For this to happen, the conditions applied –, though stringent in terms of policy – will have to be favourable as regards interest rates and repayment schedules. For the euro zone’s European Stability Mechanism (ESM) of €500bn, the amount required to rescue Cyprus is relatively small, but that does not make it easy from a political standpoint. A haircut on sovereign debt as already applied to Greece (itself exacerbating the problems of Cypriot banks) would damage the credibility of the insistence by euro zone policy makers that that the Greek haircut was a one-off and so could have adverse repercussions across the euro zone.
A bail-out, especially one on favourable terms, itself faces resistance from creditor countries like Germany and the Netherlands, because such a rescue would in part go to rescue banks from the consequences of expanding deposits from often dubious sources. For this reason a bail-in of large deposit-holders has been mooted. This would be a powerful discouragement to the use of small countries as tax havens but it would be disastrous for the Cypriot economy given the importance of its banking sector. But any bail-out should insist on increased transparency for bank deposits. This should apply even if tax evaded is in a non-EU country like Russia.
To get back to managing its sovereign debt and stabilising its banking sector, Cyprus is likely to require ongoing support. At the very least this should be on condition that Cyprus commits to not blocking closer relations between the EU and Turkey bearing in mind that it was the Greek Cypriot side not the Turkish Cypriot side which in 2004 blocked the most recent UN-led effort to solve the division of the island. Ideally, although that would require careful and skilled diplomacy, rather than threats, the Greek Cypriots should be persuaded into new negotiations on ending the stalemate in which part of the island has for almost 40 years, been under the authority of an entity, the Turkish Republic of Northern Cyprus, which is only recognised by Turkey.