Iceland's harsh cure would be a better medicine for Cyprus

Volcano island survives after its economy shrank thanks to capital controls and a devalued currency – but it wasn't a member of the euro

PUBLISHED : Tuesday, 26 March, 2013, 12:00am
UPDATED : Tuesday, 26 March, 2013, 3:14am

A week after the European Union's first disastrous attempt to solve Cyprus's debt crisis, a new rescue package emerged yesterday.

Unlike the initial bailout, the new deal honours the deposit guarantee offered to small-scale savers.

But, account-holders with more than €100,000 on deposit at the island's largest bank will be forced to take a painful haircut, likely to cost them around a third of their cash, while big depositors at the second largest bank could be wiped out altogether.

Described by International Monetary Fund boss Christine Lagarde as "a comprehensive and credible plan", the deal secures the €10 billion the Cypriot government needs to prevent the island crashing out of the euro.

As a result, the new package was hailed as a triumph by the European Union's financial elite for preserving the European single currency intact, at least for the time being.

"The EU has largely prevailed," declared Jörg Krämer, chief economist at Germany's Commerzbank yesterday. "The Cypriot parliament will not have to approve the negotiation results."

But although the deal was greeted with relief in much of the rest of the euro zone, whether the package is really such a good outcome for either the economy or the people of Cyprus people is debatable, to say the least.

Olli Rehn, the EU's commissioner for economic affairs, was putting it mildly yesterday when he warned that "the near future will be very difficult for the country and for its people".

Cyprus' future as an offshore banking haven is now effectively dead. With large depositors forced to foot the bill for the insolvency of the two biggest Cypriot banks, international confidence in the island as a banking centre has been well and truly killed off.

Like Iceland - another island whose banking sector expanded to around 10 times its gross domestic product before collapsing in crisis - Cyprus will now have to undergo a painful contraction in business activity and in its overall economy, with an accompanying sharp rise in unemployment.

Over 2009 and 2010 Iceland's economy shrank by 10 per cent, while the jobless rate shot up from less than 1 per cent to over 9 per cent.

But Iceland back then had a crucial advantage over Cyprus today: it wasn't a member of the euro.

That meant the Icelanders were free to impose capital controls and to let their currency devalue.

Over the next year the krona lost 60 per cent of its value against the US dollar.

The treatment was painful, but effective. The shock pushed Iceland's trade balance from deficit into surplus. Growth recovered to a 2.6 per cent rate in 2011, and unemployment fell back towards 5 per cent.

Today the Icelanders are undoubtedly chastened, but at least their economy looks relatively healthy.

As a member of the euro, Cyprus will be denied Iceland's route out of crisis.

Although the terms of yesterday's rescue deal allow the Cypriot government to impose some restrictions on capital outflows, it is doubtful how effective controls can be while the island retains its euro membership.

In any case, Cyprus cannot devalue as Iceland did and get the same sort of stimulative shot in the arm that comes from currency depreciation.

As a result, there is a very real risk that the island's economy is heading for a contraction so deep and protracted that Cypriots will actually see their debt to GDP levels increase sharply, not decline, as a consequence of yesterday's deal.

In a year or two, Cypriots could find themselves bitterly regretting yesterday's rescue, and envying the good fortune of their Icelandic counterparts in being free to suffer the harsh treatment denied to Cyprus.