Cyprus Is Doomed: Why the Country Must Leave the Euro Immediately

What if doing the right thing in Cyprus bankrupts Cyprus?

That's not so much a "what if" as a "what is". The finally agreed to Cypriot bailout and bail-in will save the Cypriot financial system by destroying it, along with the rest of their economy. In other words, Cyprus has traded default for depression, instead of devaluation. But this depression -- and it will be a capital-d "Depression" -- will make staying in the euro a political and economic nightmare. The sooner Cyprus wakes from it and abandons the common currency, the better. 

The tiny island has become the epicenter of the latest round of euro-angst after its too-big-to-save banks got in need of saving. Those banks had inflated to seven times the size of the €18 billion ($23 billion) Cypriot economy due to massive inflows of (sometimes illicit) offshore money, mostly from Russia, looking to dodge taxes back home. Now, there are plenty of tax havens around the world, but none of the others made the balance-sheet-destroying mistake of investing in Greece. That left Cypriot banks woefully undercapitalized. And the Cypriot government was woefully unable to fill their capital holes.

That's when the tragicomedy of errors began. Cyprus, Russia, and the so-called Troika of the European Commission, European Central Bank, and the International Monetary Fund, entered into a potentially high-stakes game of chicken over who would pay for the island's insolvent banks. First, Cyprus rejected the Troika's plan to wind down its two biggest and most troubled banks; then rejected the Troika's backup plan to tax insured and uninsured bank deposits; then got rejected by Russia in its bid for a Hail Mary loan; and then, finally, under pressure from the ECB, agreed to ... wind down its two biggest and most troubled banks. In other words, it was a productive week, if their goal was to achieve nothing other than destroying all confidence in their economy.

Not that much confidence is justified. The ultimate deal in Cyprus was right on the merits, but those merits will leave its economy in ruins. Cyprus got €10 billion ($12.8 billion) from the Troika to bail out its government, and, in return, agreed to "bail-in" bank creditors to pay for its bank rescues. Here's how the bail-in is going to work.

-- Laiki Bank, Cyprus' second-biggest, will be shut down, and split into a good and bad bank. The good bank will get all insured deposits of €100,000 ($128,000) or less, and €9 billion ($11.5 billion) of assets used to get "emergency liquidity assistance" (ELA) loans. The bad bank will be capitalized by wiping out shareholders, bondholders, and uninsured depositors. The latter will recover whatever money the bad bank gets from selling off its toxic assets -- but that's not expected to be much. Cypriot officials estimate uninsured depositors at Laiki could face losses of up to 80 percent.

-- The Laiki good bank will be merged with the bigger, and just as insolvent, Bank of Cyprus. This new mega-bank will be recapitalized by, again, wiping out shareholders, bondholders, and uninsured depositors. The latter will, again, recover whatever money isn't needed to get the new bank to a 9 percent capital ratio. Officials expect these uninsured depositors could face losses of 40 percent.

-- Cyprus will put in place "temporary" capital controls to prevent depositors from pulling their money out of the country en masse. In other words, a euro in Cyprus is stuck in Cyprus. Or at least that's what the authorities hope. Among other things, people won't be allowed to cash checks, close out term deposits before maturity, take more than €300 ($384) out from each bank a day, take more than €1,000 ($3,440) of the country for trips, buy more than €5,000 ($6,400) with credit or debit cards abroad, or send more than €5,000 to overseas students each term. These restrictions are only supposed to last a week, but they could easily go until May -- if not much longer. (As Hugo Dixon asks, how many academic terms are there going to be in the next seven days?). Indeed, Iceland introduced its own supposedly short-lived capital controls back in 2008, and still hasn't lifted them.

This was the right thing done at the wrong time. In principle, bank creditors should pay for bank rescues (if done the right way). And offshore tax havens should get, euphemistically-speaking, "reformed". But doing so now leaves Cyprus with very little hope for any kind of future. It's just been hit by three mega-shocks: fiscal, financial, and wealth. For one, its age of austerity is just about to get more austere, as the Troika demands further tax hikes and spending cuts in return for its €10 billion bailout loan. For another, its bail-in and capital controls will effectively kill off its financial sector -- which now makes up 18 percent of its GDP -- and starve its people and businesses of credit. Even worse, those people and businesses are going to need credit now more than ever after losing so much of their wealth in the bail-in.

In other words, Cyprus is about to collapse.

It's not clear just how great this depression will be, but the early estimates are, well, depressing. As you can see below, the International Institute of Finance thinks Cypriot real GDP could fall as much as 20 percent over the next few years. The difference between the green and red lines shows just how destructive the last week has been for Cyprus.

Default is just another word for nothing left to lose. The question now is how much Cyprus has left. Not much, it seems. Its banks are dead, its real economy is about to go into deep depression, and its people are particularly ambivalent about the common currency. It's not hard to imagine these facts adding up to euro-exit at some point in the future. The faster that future arrives, the better.

Cyprus has nothing to lose, but too tight money.