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Cyprus, the Day After

Stormy weather at Cavo Greco, Cyprus
Tomasz Huczek | Flickr | Getty Images
Stormy weather at Cavo Greco, Cyprus

The Cyprus economy was well into a recession before March 25, when the euro zone leaders agreed to the closure of the second largest bank, Laiki Bank, and a haircut on the deposits of the largest bank, Bank of Cyprus.

During 2012, Cyprus's gross domestic product (GDP) contracted by 3.1 percent and the forecast for 2013 was also a contraction of around 4.5 percent.

Unemployment was increasing with incredible speed and had reached 15 percent of the labor force in February 2013. Three years ago, unemployment was just 5 percent.

After the decisions of the Eurogroup on March 25, the Cyprus economy is in a very bad situation with a broken banking system pushing the economy into a deeper recession, which can develop into a depression.

The banking system in Cyprus may be better capitalized now, after the conversion of a sizable percentage of deposits into tier 1 capital for the Bank of Cyprus and the injection of 2.5 billion euros into the capital of other financial institutions. However, it is missing the most important ingredient, which is "trust".

No banking system anywhere can survive without trust and once you lose trust, it is difficult to get it back. It may take years before depositors can trust the banking system in Cyprus.

Even if it has been declared many times that deposits up to a 100,000 euros per person are secured, depositors are very skeptical since they don't trust the politicians either.

Even if depositors accept the argument that deposits under 100,000 euros are fully insured, the government may not have the money to pay in case another financial institution goes bankrupt.

The billion dollar question that lies ahead now, is whether the Cyprus banking system can survive the pressures once the restrictive controls are lifted in the near future.

The restrictions on the free movement of capital within and out of Cyprus have been imposed by the central bank in order to avoid financial panic but they cannot last forever.

The restrictions have already caused huge damage to the economy of Cyprus and if they last longer, the damage will be even greater. Thousands of businesses are practically operating without any liquidity since most of their money is tied up in their bank accounts.

It is very difficult to predict what will happen if the restrictive measures are not lifted. But it is also very difficult to predict what will happen if the restrictive measures are lifted.

A veil of uncertainty covers the banking system today which kills economic activity. The European Central Bank has promised unlimited liquidity to the Cyprus banking system once the restrictive controls are lifted. But according to the rules of engagement of the Emergency Liquidity Assistance (ELA), liquidity is granted to solvent and well capitalized financial institutions provided they provide adequate collateral.

So, if the economy continues to sink deeper into a recession, the amount of non-performing loans will be increasing, and the financial institutions in Cyprus may need more capital.

What was described as the worse case scenario, may now be a highly probable event. And then Cyprus may enter a vicious circle of recession, non-performing loans and bank failures. I wouldn't be surprised if the new "bail-in" model of handling bank crises that was applied in Cyprus by European leaders may turn in to a nightmare for the euro zone as a whole.

Marios Mavrides, is a member of parliament for Cyprus's ruling DISY party and also a member of the House Standing Committee on Financial & Budgetary Affairs. He is also professor of economics at the European University.

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