Drastic surgery to ease Cyprus' suffering

There are some similarities between economic policy making and being a doctor. Most of the time a little bit of tinkering here, some tinkering there and the problem is fixed.

For economic policy it might be a small tax increase, trimming back some spending or an interest rate hike that does the trick. For a doctor, it is hopefully some antibiotics or a few stiches in the wound that helps the patient and in a short time, things return to normal.

But sometimes for a doctor, amputating a leg or removing an organ is the best treatment. Sometimes open heart surgery is the option that will give the patient a chance at life.

And for economic policy makers confronting a sick or near ruined economy, sometimes it is across-the-board spending cuts, substantial tax hikes, closing a bank and even a bank deposit levy that are needed to keep a country or its banking system solvent.

This is the sort of dilemma facing Cyprus. A panadol and a good lie down were never going to fix the problem. If government debt default and widespread bank failures were to be avoided, radical policy changes were going to be needed and they had to be implemented in a clinical way, however unpleasant they seemed to be, however scary the short-term consequences were.

With help from the European Union, the International Monetary Fund and European Central Bank, the so-called troika, it looks like the radical policy changes announced by Cyprus in the last 24 hours just might work. At least in the short run.

The Cypriot government of President Nicos Anastasiades has implemented what it is calling a ‘macroeconomic adjustment program’ that saw it meet the criteria which enabled Cyprus qualify for €10 billion of bailout funds from the troika. The program includes measures to shut Cyprus’s second largest bank, the Cyprus Popular Bank, with a deposits tax imposed on all balances in excess of €100,000.

The measures for the banking sector, in concert with a range of other fiscal austerity measures announced previously, including tax hikes, spending cuts and reductions in government employees and wages, are aimed at limiting the rise in government debt to GDP to 100 per cent by 2020.

The net effect, at this early stage at least, is that Cyprus will remain in the eurozone and its government is solvent. Had Anastasiades failed to deliver on these banking and other austerity measures, the bailout or rescue funds from the troika would not have been delivered and clearly, the whole Cypriot banking sector would have collapsed and with it, the government would have defaulted on its debt obligations. In other words, Cyprus would have been at grave risk of being booted out of the eurozone. Market speculation would have intensified, asking which ‘country is next? Spain? Italy?’

It simply could not happen.

Summing up the relief with the policy outcome, IMF Managing Director Christine Lagarde said the decision of the Cypriot government and the troika bailout was “a comprehensive and credible plan”, while the Finance Minister of Cyprus, Michalis Sarris simply said, “it’s not that we won a battle, but we really avoided a disastrous exit from the eurozone”.

Moody’s ratings agency was more skeptical, noting that “even in the best-case scenario, where the Cypriot parliament passes and implements measures that the euro area governments of the … troika find acceptable, the sovereign [Cyprus] will remain at risk of default and exit from the euro area for a prolonged period”.

To be sure, with Cyprus now condemned to a deep recession for the next couple of years, building tax revenue and restoring confidence will be difficult. There are risks ahead which may yet see further bailouts required. Time will tell.

After a knee-jerk surge in market optimism after the package was announced, financial markets have since reacted with caution, with general doubt and uncertainty the main themes. European stock indices were weaker overnight with falls of at least 0.5 per cent and up to 2.5 per cent. This nervous mood was also evident in the US with Wall Street stocks weaker.

Perhaps more telling was the reaction of currency markets, where the euro weakened, to be down over 1 per cent against the US dollar.

The threat of economic collapse saw the Anastasiades government deliver a range of policy solutions that were tough, nasty, unfair and a little frightening. While the initial market reaction has not been kind, the changes were necessary medicine to slowly but surely repair the Cypriot economy over the years ahead and to see the eurozone hold together.