Who wins, who loses in Cyprus from a disorderly euro exit?

04 April, 2013 | Posted By: Fiona Mullen

 * So finely balanced that geopolitical considerations will decide *

By Fiona Mullen
Director, Sapienta Economics Ltd

Debate has been raging lately within Cyprus about whether or not the country should cut its losses and leap out of the euro, telling all of those who have lent us money for the past ten years, including the European Central Bank, that they have to wait for their money.
The arguments in favour of an exit emphasise that staying in the eurozone is likely to mean years of growth-strangling austerity, while the arguments emphasise the still fragile banking system, saying it would not survive a collapse and we would be in an even worse position without it.
For some recent arguments in favour of keeping the euro, see Michalis Persianis at . For a more academic approach, see Alex Apostolides at . And for a recent argument against (in Greek), see Christos Savva at .
Those of you who have been following me on Twitter will know that I have wavered back and forth on this question. In the space of the same week, I have said, “Better to be a free man than a slave with the same debt” as well as, “Trust me if we left euro tomorrow there would be no banks at all.”
My usual instinct when in doubt is to go look at the numbers. Below I have devised a simple model to identify the winners and losers for each different sector. Each answer is then weighted according to the size of each sector.
For these purposes, it is better to use gross value-added (GVA) than gross domestic product (GDP), which includes GVA plus VAT and import duties. So, for example, if agriculture is only 2.3% of GVA, then it’s a win via exports that could be up to 75% cheaper will only have a weighting of 0.023 in the overall winners’ score.
“Activities of households as employers” (housemaids) is only 1.4% of GVA, so it’s a lose (being paid in a falling Cyprus pound will not be attractive to them) will only have a weighting of 0.014 in the overall losers’ score.
Among the bigger sectors, financial services (9.3% of GVA) and professional services (6.1% of GVA), are clear losers. You only have to look at the growth in these sectors after Cyprus joined the EU and the eurozone to realise that eurozone membership is a big plus for them.
Some sectors have both a win and a lose. Construction, for example, at 6.2% of GVA, would find that imported raw materials, of which petroleum products is a big part, would be up to four times more expensive, but it would mainly be a win because of the influx of foreign buyers to snap up cheap real estate.
So, construction gets a 0.75 win and 0.25 lose. Mining and quarrying, which depends on construction, is treated the same.
Education would lose in terms of public-sector education, where expenditure would be scaled back, but would win in terms of tertiary education, which would become more attractive to foreign students. So education gets a 0.75 win and a 0.25 lose.
The only sector in which I have had to estimate the split between the two major groups is accommodation and food services. For the full methodology of how I calculated the proportions of accommodation and food services respectively, see the methodology at the back of the PwC “Professional Services: Driving Jobs and Growth in Cyprus” report, which you can find on my website.
Accommodation (tourism) is a clear winner, whereas food services is primarily a loser, via the higher cost of food imports.
Once a win/lose score is given to each sector, then multiplied by its relative weight in the total economy, we can add up all the winners and add up all the losers.
Now here is where I was surprised. Having clambered back over the “euro in” fence this week I expected the score to show staying in the eurozone as a clear winner, at 60% or more.
In fact, it is much more finely balanced than that: only 52.3% in favour of staying in and 47.7% in favour of getting out.
And given that there will be differences in opinion on, say, how much construction wins and loses, you could say that if you use my approach the economic arguments for and against are actually 50:50.
Of course, a crude approach like this does not take into account the “multiplier effects” in both directions. In the euro, we only need to look to Greece and the rise of the far-right Golden Dawn for the social effects. Migrant workers were petrol-bombed earlier this week, so we cannot pretend that it won’t happen here.
But out of the euro, there are other multiplier effects that would be felt within weeks.

With no foreign reserves, food imports could stop within weeks
First and foremost, we would have to defend our own currency with foreign exchange reserves. But precisely because we are in the euro, we barely have any.
We can see what the ideal foreign exchange levels should be from what we had before adopting the euro. While we still had capital controls and we were still a long way from the euro, we had $1.7 bln in FX reserves according to IMF data, or about 4 months of “import cover”.
Import cover is the amount of foreign currency that could be used in emergencies to pay for imports of goods and services if no other money is coming into the country.
As we started to lift capital controls in 2002, and money could leave more easily, we had to lift reserves to make sure we could defend the value of the currency. In terms of import cover, they peaked at 7.3 months in 2006 (the year, if I remember right, that we entered the Exchange Rate Mechanism), and in terms of dollars they peaked at $6.1 bln in 2007.
Then we adopted the euro and our FX reserves tumbled, probably owing to ECB rules. By 2012 we had just $449 mln in reserves or only two weeks of import cover.
That means that if we fell out of the euro and did not impose even more stringent capital controls than we have now (which would also starve investment), the electricity would go off and the food would dry up within a few weeks unless someone pumped an awful lot of money into Cyprus.
One counter-argument to this is that we should build up reserves and ask the EU for an orderly exit. But that would need the agreement of the Central Bank of Cyprus. And one lesson Cypriots have learned this week is that the Central Bank might be independent of the government but it is not independent of the European Central Bank, of which it is a board member.
The ECB will want its estimated EUR 14 bln Emergency Liquidity Assistance (ELA) back, so it could be reluctant to take the risk of another experiment with Cyprus.

Geopolitics will decide
My personal view is that the geopolitics will decide. A disorderly exit from the euro will almost certainly lead, via default on a lot of EU debt, to an exit from the EU. Cyprus would then be alone and vulnerable, with the Turkish army on one side and the British army on the other.
Cypriots have been there before and they will not want to go back there again.
So unless there is such a thing as “leave the euro but stay in the EU”, Cyprus will probably remain stuck in the euro, with all the austerity and bitterness towards Europe that this entails.