Why Plan B/C is bad and the only two options for Cyprus

From what we have learned over the past few days is that Jeroen Dijsselbloemhas been put at the dock for not believing in any alternatives for Cyprus during last Saturday's Eurogroup meeting, the ECB will deny any access to ELA funding unless a deal is reached and Russia will not financially support the small Mediterranean island. In addition, we know that Cyprus is systemic and that they are working on Plan B, C or whatever alphabet letter they have reached up to know.

Yesterday, plan C was presented: it proposed the break-up of Laiki bank into a "bad" bank/"good" bank scheme with deposits up to €100,000 guaranteed by the state. The good assets from Laiki bank will be merged with the ones of its competitor, the island's largest institution, the Bank of Cyprus PLC. This will supposedly the state from finding €2bn and as they will raid provident funds for an additional €2.8bn they will only be about €1bn short. A solidarity fund will be created for that money and Central Bank and the Finance Minister will have the power to impose capital controls. State assets may aslso be used as collateral for securing loans or bonds. Sounds good doesn't it? The only problem with this plan is that it's STUPID!

First, unemployment in Cyprus is on the rise, moving faster than any other in the Eurozone. Thus, private consumption is declining. Shutting down Laiki bank will mean that an additional 2,000 people will enter unemployment directly and many more indirectly. Which will sink the nation further into a recession which will probably outlast the decade and destroy every potential for growth not to mention the banking system. In addition, creating a bank which will probably be 5 times the country's GDP is not a good option. If the recession continues then BoC will need further assistance from the state; a state which cannot afford such moves. Moreover, if they use the employees provident funds and lose them what will the employees receive as pensions? Thank you notes from a defaulted government?

In one simple sentence: The plan will not work because it is promoting recession.

As far as the assets are concerned their value is extremely subjective. If I am not interested in living in Cyprus, or if no other person is then why should I believe that these assets are worth as much as they claim they do? In simple words you sell at a discount; a very big discount. The same logic holds for selling rights in gas plots: if you sell them now, where this appears to be just speculation you will sell very, very cheap. If these deposits actually exist then it would be much better if they kept them for the next 2-3 years and not sacrifice years of income for just a really small percentage of what they are worth.

What are the alternatives then? First we have to distinguish between two options:

In option 1 there is really no alternative but this. Anything else cannot possibly exist except if the EU decides to give more assistance via the ESM funds.

Option 2 is much more interesting. Paul Krugman states that Cyprus could make it although he questions the leader's willingness to push through with such an issue. Yet even if they were, the outcome of such an action would be highly questionable. A devaluation of about 40% is expected by most economists with unknown consequences in buying power within the island. Alex Apostolides (via Twitter) believes that the consequences of a return to the pound would devastating for the Cypriots as prices of imported goods will rise extremely.

What we seem to be forgetting here is the fact that Cyprus is autarkic when it comes to basic goods. It produces (and even exports) every basic good which is sold in the market, from vegetables and fruits to wine, bread, milk and beer. Although I am not sure whether fertilizers and animal feed are imported or not, this is the only expense producers are about to have. Thus, the damage to the local population will be minimal in terms of basic goods.

As far as prices are concerned, changing a currency always promotes an increase in the level of prices not matter if the previous currency was strong or not. Thus, a better proposal would be to equate 1 Cyprus pound to 2 euros. This would mean that prices will essentially be slashed by exactly 50% and will avoid the kind of rounding up that occurred when prices were converted using the 0.585274 rate. Will this exchange rate hold? Not a chance. Since Cyprus needs to print a significant amount of money to liquidate its banks the exchange rate will fall soon enough. Yet, not before every price is converted to the pound. 

Barry Eichengreen's excellent article on different Eurozone exit scenarios, presents some interesting stories of previous schisms in monetary Union. The secret for doing the conversion is to make it as fast as possible; not longer than two-three days. In addition, all carriers of Euros should not be allowed to change more than 5,000 to pounds. All the rest should be deposited in banks. In order to avoid bank runs from foreigners (as residents have no incentive to do something like this) harsh capital controls regarding transfers between Cyprus and the rest of world should be enforced.

What we have not yet discussed is tourism. If approximately 1 million tourists visit Cyprus every year, then a significant money influx is poured into the country's system. This will safeguard the exchange rate and will stabilize it from further threats. In addition, a weak pound will assist Cypriot exports and make any income from the banks' operations in Greece appear more significant in terms of local currency.

Are there any drawbacks to this? Aside the major political issues which may arise, this may hurt the island's banking system. Russia flow of funds will not be significantly affected since the merely change the currency to euro and the ship the funds back to their homeland. The only difference will be that they will change it to pounds now, although many banks were offering euro accounts before the initiation of the euro in the country, a thing they will most likely do once again. Yet, if some companies are not willing to assume an exchange rate risk (which will be high especially in the first couple of years) then this will see some companies exiting Cyprus.

One of the newest studies on the Cyprus exit scenario, comes by Alex Apostolides (based on 2009 data). In it, he argues that a 40% increase in the price of oil could contract Cyprus's GDP by approximately 1% (slide 8), with most of the effect arising from the electricity, gas, steam and air conditioning sector. In addition, increased electricity cost will also mean another 0.5% contraction in GDP if it affects other industries as well. Nevertheless, it is possible for this to be offset if the provider chooses to have a lower profit margin (we cannot possibly know the profit margin thus this is just a possibility). A probable scenario under his analysis will mean that a 40% shock on the price of oil, may cause up to 8% contraction of GDP, while the worst case scenario may reach a 15% contraction of GDP. Hyperinflation issues may also occur if the government budget is not balanced (which will be difficult since the country will need a significant amount of money for bank recapitalization). In addition, prices will also increase due to supply shrinkage, making the whole situation quite messy.

To sum up, the island is faced with two options: either stay in the euro or exit the euro. Both can be done and both entail a significant amount of risk. At the end of the day, it boils down to politics. And let us not forget: if Cyprus exits the Eurozone then Italy (and maybe Spain) will most likely follow suit. Then we can just kiss the Monetary Union goodbye.