Last week saw the much-diminished Cypriot banking system finally re-open, albeit with onerous capital controls in place. These include limits on credit card transactions, daily withdrawals, money transfers abroad and the cashing of cheques. A large proportion of deposits over €100k at the now-defunct Laiki Bank and Bank of Cyprus, remain frozen, while the final haircut to be imposed on them is decided. And while the government says that the capital controls will be gradually eased, some look set to remain in place for many months, and possibly years.

The precise impact on the economy of the events of the past couple of weeks, the harsh austerity required under the bailout package and the long-term imposition of capital controls is impossible to tell. But a contraction in GDP of at least 10% this year now looks entirely feasible, with something similar not unrealistic next year too, with unemployment rising above 20%. As the chart below shows, if that were to happen, it would leave the performance of the Cypriot economy similar to that seen in Greece following its own bailout. And, of course, if GDP does shrink by this much, the current bailout package will not be the last – the damage inflicted on the economy has evidently left a hole in the bailout programme that will need to be filled one way or another. And with Cyprus’ euro area partners having been resolute that €10bn is the maximum it can expect from them and the IMF, and seemingly in no mood to cut Cyprus any slack, the Cypriots themselves can be expected to have to meet the bulk of the shortfall, with additional austerity serving to put even further downward pressure on the beleaguered economy.

GDP in post-crisis countries

*Assuming a 10% drop in Cyprus GDP in both 2013 and 2014. Source: Datastream and Daiwa Capital Markets Europe Ltd.

Cyprus therefore faces a bleak economic future, in the near term at least. And it begs the question whether, when the history books are written, the conclusion will be that it should have taken the opportunity of the past couple of weeks to leave the single currency altogether. The argument has always been that the costs of leaving the euro will always outweigh the benefits, not least as a result of the damage to the financial system that would result in a forced redenomination of deposits. But in some ways that is what Cyprus has seen over the past couple of weeks – a multi-day bank shutdown (Cyprus had 13 consecutive days of closed banks) the closure of a major financial institution and the introduction of strict capital controls is exactly what would be needed if a country was to take the decision to leave the euro. Indeed, Cyprus now stands one step removed from the rest of the euro area – a euro in a Cypriot bank is clearly not worth the same as one in any other bank across the single currency. The unprecedented imposition of capital controls within the euro area fundamentally undermines one of the key benefits of membership of a single currency – the free movement of capital without exchange rate risk. So, euro member or not, Cyprus is likely to be last on the list of any international firm planning foreign investment. Cyprus has therefore been on the receiving end of most of the costs associated with euro exit, but without being able to reap the potential benefits.

Most important of those benefits, of course, would be the reintroduction of independent monetary and exchange rate policies. While a large exchange rate depreciation for any country is by no means a panacea, for a country such as Cyprus which has effectively had one of its largest industries, its banking sector, ripped asunder, the required rebalancing in the economy would almost certainly be eased by improved cost competitiveness via a weaker currency, not least for the important tourism industry. An independent monetary policy, meanwhile, if established with appropriate checks and balances (admittedly a big ask) might, eventually, be able to provide more appropriate support for the economy than the ECB.

So, despite all of the costs that euro exit would entail, it is far from clear whether a decision to leave the euro would really have left Cyprus facing a larger contraction in GDP than can now be expected. Iceland is by far a perfect example of a post-crisis path for GDP for a post-euro Cyprus, given that it didn’t see a currency conversion. But it did see the closure of the banking sector and the imposition of capital controls, which remain to this day. Helping to offset that, of course, was an exchange rate depreciation of more than 40% against the euro in the course of 2008. And, while Iceland’s GDP remains well below its pre-crisis level, it has seen nothing compared with the destruction wrought in Greece, and which looks entirely plausible as the outcome in Cyprus. If nothing else, Iceland demonstrates that your economy doesn’t necessarily have to shrink by a quarter in the aftermath of a financial crisis.

But Cyprus’ best opportunity to leave the euro has now passed. Having eschewed the option over the past couple of weeks, to now decide to leave at a future date would entail another major shock to the domestic economy. That would make a terrible situation even worse. But as the dust settles from the frenetic events of recent weeks, and the price that Cyprus is going to pay for its bailout within the euro area becomes increasingly apparent, its citizens are likely to increasingly reflect on whether leaving would have been better in the long term. And for a country where support for euro membership is already the lowest among euro area countries, and where much of the economic pain is yet to come, the question of whether Cyprus could ultimately become the first country to leave the euro may never be too far from the surface. Certainly, despite its tiny share of the euro area economy, we haven’t heard the last of Cyprus.

Grant Lewis, Head of Research