Wednesday, 10 April 2013

The Economic Consequences of a CY-Exit

Ever since the latest Cyprus fiasco, many have been wondering whether a country exiting the Eurozone could be a possibility. The fact is that the Eurozone cannot evacuate a country as it will set a precedent (not that setting a precedent seems to bother them a lot, given that lately we have learned that every deposit over €100,000 is not safe). For the sake of argument we can assume that the Eurozone leaders can understand that if one country exits then it is only a matter of time before more leave; thus it is to their better interest to keep every country in the monetary union.

In addition to the assumption that leaders do understand the consequences of their actions, we will also assume that the exiting the Eurozone will allow the exiting country to remain in the EU which means that forcing it out will not forbade it from the common market (details on the subject will be discussed later).
To make things more specific, Cyprus will serve the cause of a case study. 

We know that Cyprus has an 87% debt-to-GDP ratio, a ratio slightly more than the EU average of 81%. As stated in a previous post, Cyprus currently has €9bn of her debt held by domestic creditors. Thus, even under the English law (which does not allow for any changes in the bond structure) if more than 75% of creditors are in agreement then the bond terms can by altered. One can only assume that the Cyprus Central Bank can excess some kind of pressure to the state creditors making them agree on longer duration and lower interest rates (from the creditors' point of view this would not be a bad deal; the alternative would be default and losing all the invested funds). Thus, if this can happen in Cyprus then it is not irrational to assume that it can happen in every other EU nation.

Re-structuring the domestic debt means less expense for the government for the next 10-20 years; the excess could be employed to boost the economy. Then, according to Alex Apostolides an additional €3.9bn would be remain (the rest was bank recapitalization needs which after the fall of Laiki bank are no longer needed), in addition to approximately €5-6bn of ELA money. Then the matter of which issue has more seniority arises. According to Megan Green:

Thus, in the case of an exit, ELA debt and any other European debt (such as Target2 balances) would be equal to every other issue. Then, if Cyprus (or any other country for that matter) chooses to partially default on debt repayments the ECB cannot do anything more than seize assets (which I doubt since it is not senior to any other debt and no actual assets are being on mortgage when a bond is issued-unlike bank loans). Under those terms the ECB would be forced to re-structure any loans it has made to Cyprus (again, the other alternative would be default).

Then we move to the trickier parts of the equation and first of all how will the new currency be introduced. An award-winning paper on Euro-exit states that at the time of the exit, the new currency and the euro should be at a 1-to-1 parity and that euros should be allowed for small transactions for a further 6 months. The first issue that has to be made clear here is that in the case of a euro exit, the new currency and the euro cannot co-exist for more than a week. Many have been arguing for parallel currencies yet, as history has shown and common economic sense dictates, this will cause much trouble.

The reason is simple: assume that on the first day the new currency will have a 1-to-1 parity with the euro. Nevertheless, the new currency will suffer a severe devaluation within the first hours (minutes?) of trading. Thus, if we assume a 40% devaluation as the most popular scenarios do, it would make 1 unit of the new currency equal to €0.60, which would mean that prices would have to be altered again as it would mean that now what cost €1 should cost 1.4 units of the new currency, just to make up for the exchange rate losses. Making matters even worse, the rate would not be at all stable during the transition period. 

A possible solution would be either to peg the new currency to the euro at 1-to-1 parity. However, this would never hold as the George Soros pointed out to the Bank of England in the 1990's. In addition, the willingness of Brussels to do that for a "traitor" is highly questionable. The only remaining alternative is a short transition period and capital controls through it. In order for the transition period to go without any severe effects on the economy (the two-week bank "holiday" is expected to cost approximately 2% to the country's GDP) it has to be fast and swift, with capital controls loosening significantly after it (unlike the very slow steps taken now). 

The only real problem faced by any nation who wishes to exit the Eurozone is inflation. The award-winning paper suggested that:

"The exiting country would immediately announce a regime of inflation targeting, adopt a set of tough fiscal rules, monitored by a body of independent experts, outlaw wage indexation, and announce the issue of inflation-linked government bonds.It also recommends that government should redenominate its debt in the new national currency and make clear its intention to renegotiate the terms of this debt."

The only trouble with the above is that inflation targeting does not assist in the short-run, where the economy will face harsh problems through increased energy prices. In addition, all of the proposed measures are more for the sake of credibility than actual good (in the short-run that is). Although inflation would be needed as a means to boost the economy, too much of it will prove to be disastrous, especially with regards to imports (it has been suggested that deposits will lose their value. This is not an issue per se for residents as everything will be evaluated in the new currency. This is only an issue with hyperinflation and increased import prices).

Economic theory (and practice) indicates that there are the following determinants of an exchange rate:
1. Domestic Money Supply/Inflation and Interest Rates
2. Import demand and Export Demand
3. Productivity (with respect to other countries)
4. Current Account balance and the Trade Balance
5. Domestic Reserves in Gold and other currencies

Another issue which cannot be measured is investor/speculator sentiment. For example, although the US has employed three rounds of monetary expansion (commonly known as QE) the euro continues to depreciate against the dollar because of the Eurozone uncertainty. We will return to that later.

The following data are before Cyprus's entry in the Eurozone (in 2008) and shall assist us in determining the needs of the country for a stable currency (click on the image for enlargement):
The above graph indicates the exchange rate between USD and CYP (the reason for not choosing EUR/CYP is of less history and the fact that energy prices are quoted in dollars). The exchange band of the currencies fluctuated from a low of $1.44 per CYP (in late 2000, after Cyprus's stock market bubble crashed) and $2.5414 (in late 2007, perhaps due to the sub-prime lending crisis). In the meantime, Cyprus's other indicators were:


 In contrast to the views of many, it appears that from 2001 until 2007, when the CYP/USD rate was increased by 76%, money supply rose by 191% and foreign reserves by 112% (at their all time high). Inflation was rising during the period, with an approximate increase of 21.4% (or approximately 3% per year).
In addition, the current account was not doing any better either. The data show that as it reached its all-time low (by then) in 2001, the exchange rate did not resume its fall (it moved within the same band for about a year), and the year-end CYP/USD rate was actually increased. In addition, CYP continued its appreciation (reaching the all-time high) regardless of the fact that its current account reached new depths in 2007.
The Import/Export data do not show any significant difference over time either. Their average was pretty much zero until 2004, when the Trade Balance fell continuously until 2007. Yet, however, the CYP increased in value.
Oil prices are always important in an economy.Yet, although oil price rose from 1996 to late 2000 by 70% and the exchange rate fell to approximately $1.50, thus forcing the price of oil to rise more than 130%, real GDP rose by approximately 0.94% per quarter.

The last part of economic theory is interest rates: if interest rates are high, the investors/speculators will want to hold on to the currency; if they are low they do not wish to hold any of it. Yet, as interest rates are higher in a country, higher inflation appears and growth is supposed to be less than it could potentially be if the rates had been lower. 
Having an extremely high interest rate in 1999 did nothing to stop currency deterioration. As the reader may recall, the lowest point of the USD/CYP pair was in late 2000, just before the interest rate was lowered. As interest rates dropped to an average of 3.5% (which again is very high compared to other nations), the currency started appreciating.

In comparison, Cyprus today (as of 2012Q3) stands at:
- minus 990m on the current account (48% less than 2007 but 10% more than 2006 although the full year total will probably be less than 2006)
-341m of reserves (less than any period since 1995)
-101m of forex reserves (again an all-time low)
-563m in gold (an all-time high due to the increased price of gold)
-Deposit rates at about 3-3.5% for term deposits
-The least Balance of Trade (-1bn) it had over the past 8 years (since 2005)
-A slowing inflation (up just 1.2% in 2012 and expected to be near zero in 2013)

The only problems in Cyprus's position are foreign reserves and general reserves. The catch here is what Paul Krugman has been stating and many (including many Cypriots) ignore: 

-Income from tourism in 2012: €1.927bn or approximately 11% of GDP. (The income was actually higher in 2001 when the CYP was in place)

Such an influx of money (which will be even more if the depreciating currency brings more tourists than 2012) will increase the country's foreign reserves and help stabilize her currency. That is the reason why a euro exit should occur either before the summer season or just after it (if the island can survive until then that is). A devaluation of the new currency would in fact assist Cyprus to gain more tourists thus increasing that income.

The main cause of worry for the Cypriots should be oil prices. Yet, as the graphs have shown, rising oil prices is not the end of the world. Real estate, tourism and business services (which comprise approximately 60% of GDP) would be benefited from a devaluation of the currency, which means that more money would be pouring in Cyprus than before. This will again help stabilize the currency thus making prices less susceptible to oil shocks.

In addition, the other worry would be that of money supply. At its highest, M1 supply in Cyprus was approximately 36% of real GDP. Thus, according to data on 2012Q2, the amount of money supply would have to be roughly the same as it was in 2007 to compensate for that (i.e. €4.5bn). The amount of money used to recapitalize banks would not affect M1 as bank reserves are not included in its definition (nor are they included in the M2 definition). (This justification obviously assumes that money needed for recapitalization purposes will be treated as cash/reserves by the banks and not directly used for lending purposes).

A few paragraphs above, there was mention of investor/speculator sentiment. Imagine this: a country exits the Eurozone. Which that country is, does not really matter since once a country is out everybody else will start thinking about their own exit. Consequence: the euro depreciates. Sharply. With fears of a euro break-up, speculators will start shorting the currency driving its price down. Simultaneously, the CYP will itself depreciate, yet not such a fast pace as the euro, leaving it stronger than assumed. In addition, the USD will itself depreciate with regards to the CYP as the effects of the three rounds of QE will once again be visible. What economists seem to be forgetting in their analyses is that an exchange pair does not really count on just one currency but on both: if both deteriorate the same then the exchange rate is unaltered. 

Should the new CYP parity be 1-to-1 with the euro? Not in my opinion. The island would be better off in setting the parity a 0.5CYP to a euro to compensate for any potential currency depreciation. In addition, having the above-suggested parity would need less money supply to support it, making it both easier to create in shorter notice and simultaneously having the reverse effects of exchange rate overshooting in the short run (i.e. currency appreciation instead of depreciation).

Hugo Dixon presented the idea that Cyprus could lose competitiveness if the CYP depreciated because foreign labour will no longer be cheap. Yet, in a country with the largest increase in unemployment over the past year this will not be an issue. If cheap foreign labour force turned expensive it could easily be replaced with cheap domestic labour (unemployment is currently at 15% and rising). As for the current account having a deficit of 5% of GDP, the country never really had a strong current account balance (the least current account deficit was back in 1999 and it was approximately 4.95%).

What can be seen above is that if Cyprus wants to exit the Eurozone it is to its benefit. Although I would not strongly suggest that it does, the island has a very strong negotiating position now: it can request (or threaten) a euro-exit. Most commentators fail to see that if the country exits (or any country exits for that matter) consequences will be severe both for those who left as well as for those who are left behind. Cyprus has nothing to lose at the moment: she is facing at least a 15% decline in GDP in 2013 with no idea when growth will return. If she exits then a significant decline in GDP will also occur. The benefit though, is that it can control both its monetary as well as its fiscal policy which is much more than those which will be left in the Euro can brag about. 

If one country chooses to exit the Eurozone, either with the others' consent or without, the rest will have to live forever with the ghost of uncertainty lurking above them. Any austerity measures taken until now will appear to in vain. Which country will be the next? Will Italy, without a government and eager to relieve its citizens from the perils of austerity exit next? Will Greece? Or will mighty Germany decide to give up the throne of the Queen of Europe? Uncertainty will reign and the euro rate will collapse. Bond spreads will rise and the ECB will have to either use the OMT it has proudly presented in summer or watch it all fall like a tower of cards.

There is also another issue: whoever exits first, gains the most. Less depreciation, less uncertainty, less bond yields and more time to control its finances if (or until) someone else also leaves. As Megan Greece comments, in another example of a half-baked union "There is no mechanism through which Cyprus could be pushed out of the European Union in retaliation." In addition, there should be no country willing to kick another out of the EU just because they wish to exit the Eurozone since they can understand that their time may come soon enough. 

Thus, it can be safe to assume that Cyprus will not be etched out of the EU if it decides to return to the pound. The consequences of that are not as harsh as most people believe; yet they are not to be taken lightly. However, the island has more to lose if it remains in the Euro than if it exits in both the medium- as well as the long-run and it would be wise to use the exit scenario as a bargaining card.

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