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Cyprus is no longer centre stage. Nicosia has agreed a €10-billion ($13.2-billion) bailout deal with its euro zone partners and the International Monetary Fund. A visible bank run has been averted by stringent capital controls. International markets, which only ever suffered a mild bout of jitters, have calmed down.
But it would be foolish to forget about Cyprus. The small Mediterranean island is edging toward euro exit. Quitting the single currency would devastate wealth, fuel inflation, lead to default and leave Cyprus friendless in a troubled neighbourhood. Even so, the longer capital controls continue, the louder the voices calling for bringing back the Cyprus pound will grow.
President Nicos Anastasiades is against Cyprus leaving the euro. But the main opposition communist party wants to pull out. A smaller opposition group wants to stay in the euro but kick out the troika – the European Commission, the European Central Bank and the IMF. The country's influential archbishop is also critical of the troika.
Mr. Anastasiades can hold the line for now. After all, he has just been elected and the constitution gives him huge power. What's more, there are strong arguments for staying inside the single currency – not least the fact that, otherwise, it would lose the €10-billion (or nearly 60 per cent of GDP) of bailout money.
If Nicosia brought back the Cyprus pound, it would plummet in value. Nobody knows how much, but economists guess it might be up to 50 per cent. Cypriots are complaining at the massive haircuts suffered by big depositors in their two largest banks: Bank of Cyprus and Laiki. Such a massive devaluation would savage the wealth of all other depositors.
Meanwhile, devaluation would fuel inflation. Cyprus is a small open economy. All the oil is imported. Over 80 percent of the textiles, chemicals, electronics, machinery and automotive vehicles are imported too, according to Alexander Apostolides, a lecturer in economics at the European University Cyprus.
Cyprus also relies on cheap immigrant labour in its agricultural and tourism industries. Following a devaluation, their cost in local currency would rise. All this would mean that any gain in competitiveness would be eroded.
The island's economy would suffer a further shock because it is running a current account deficit of somewhere around 5 per cent of GDP. Given that Cyprus has limited access to hard currency reserves, this deficit would have to vanish overnight. Imports would slump. But so would domestic production, given its reliance on imports.
In such a scenario, Nicosia would not be able to avoid defaulting on its debts. Following a 50-per-cent devaluation, these would be double their current value when expressed in local currency. The debts come in two forms: the government's own €15-billion of borrowings; and the central bank's €10-billion emergency liquidity assistance (ELA) to the banks.
Default might seem an attractive option because Nicosia would suddenly shrug off a vast debt load. But it wouldn't be that simple. It would face a slew of lawsuits. What's more, if the central bank defaulted on its provision of ELA, the ECB would take the hit. The euro zone would not be happy and would, at minimum, insist on some sort of staged repayment plan.
Cyprus could, of course, refuse to pay point blank. But it is not Argentina. Its small size makes it vulnerable to being pushed around. If it tried to act tough with its euro zone partners, they would probably play hardball in return. They might even find a way to kick Cyprus out of the European Union.
Exit from the EU would be another blow for Cyprus. Its best trading opportunities are with the bloc. Most of the rest of the neighbourhood – such as Syria and Egypt – is not in great shape. And Turkey is off bounds until and unless some way can be found of resolving the dispute between Nicosia and Ankara over the latter's occupation of the northern part of the island.
Cyprus will also struggle to exploit its offshore natural gas reserves if it quits the EU. Turkey, which is already trying to stop it, would find it easier to get its way if Nicosia was friendless.
Apart from all this, the country would have to decide how to run monetary policy.
A responsible government would want to contain inflation by either linking the Cyprus pound to another currency, such as sterling, or running a tight but independent monetary policy. In either case, Nicosia would have to keep interest rates high and curb its budget deficit. It might also need to maintain capital controls.
Such an austerity program would be worse than that demanded by the troika. It would then be hard to avoid the temptation to print money. But that way lies hyperinflation.
So quitting the euro would not be a good choice. But staying is not a great one either. GDP could plunge around 20 per cent over the next two years, according to the latest guesstimates. And the longer capital controls are in place, the more the Cypriot people will feel they are not in the single currency anyway – as a euro in Cyprus is not equal to one in the rest of the world.
The troika should help lift the controls as soon as possible. Otherwise, Cyprus may well quit the euro and, small though it is, that could destabilize the zone.