Cyprus will soon be caught in the eye of the storm

2011-08-01

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Cyprus is running out of money, while interest rates in the international market are soaring. Image Source: Cyprus Mail

The Republic of Cyprus is the latest Euro member state to be contaminated by the current systemic crisis of the single currency. The catastrophic economic implications of the destruction at Vasiliko power plant, were a decisive blow, in pushing Cyprus deeper into the crisis. The impact of the catastrophe at Vasiliko has been massive, as it has significantly slowed down the economy, since it has caused serious problems in the supply of electricity, which is disrupted on a daily basis due to shortages.

Cyprus’ exposure to Greece, as well as the structural flaws of the Cypriot economy together with the event at Vasiliko, have been the reasons of consecutive downgrades by Credit Rating Agencies (the latest downgrade was by Moody’s on July 27).

The government of Cyprus has for some time now, been covering its financing needs by borrowing from the internal market. But due to the lack of a sovereign monetary policy (thanks to the euro), there has been a decrease in liquidity in the market, since the government dries out the economy and no more fresh money can be pumped in. Thus interest rates have increased, which further hinders economic activity (and only economic activity can stimulate the economy – create growth – lead to recovery from the recession).

That means that at some point the government must shift its borrowing orientations, from the internal market to the international market where things have gotten really tough, since interest rates currently are at exorbitant levels (around 13.5% for two-year and five-year government bonds)[for Greek speakers only: you can visit this page to view a full analysis of the government bonds’ interest rates].

The cost of borrowing at such rates is forbiddingly high. Should Cyprus come to the need of borrowing money to meet its responsibilities, this can only be done through a bailout mechanism, similar to what has been implemented in Greece, Ireland and Portugal.

Th situations is really tough for Cyprus and I personally see that by the beginning of next year, there will be serious pressures for the small Euro member-state to join the EFSF (European Financial Stability Facility – the mechanism that has been set up to deal with the crisis).

The underlining conclusion out of this story, is that once again events prove that the crisis is not a debt crisis of certain member states of the single currency, but a systemic crisis of the euro that has three dimensions: 1) debt crisis, 2) banking sector crisis, 3) under-investment crisis.

If EU leaders continue to pretend that the crisis is not European and instead cling to their failing, retroactive, ad hoc semi-measures we will have more countries coming to the need of a European bailout. Now Cyprus is on the queue. Who will be the next?