Cyprus Could be the Next Casualty of the European Sovereign Debt Crisis

Sources:
AP: IMF: Cyprus Growth Flat in 2011, to Shrink in 2012
Financial Mirror: IMF Sees Negative Growth for Cyprus; "Time is Up for Fiscal Measures"
FT: Cyprus Governor Warns of Emergency After Blast
FT: Mediterranean Gas Reserves Tension Flares
Fumagusta Gazette: Fule Stresses Cyprus' Right for Drilling
Reuters: IMF Says Cyprus Must Act Fast to Avoid Crisis

The International Monetary Fund (IMF) recently urged that Cyprus move forward with austerity measures if it hopes to avoid a debt crisis—and accompanying bailout—similar to the ones that have engulfed Greece, Ireland, and Portugal in recent years.

After spending eleven days studying the Cypriot economy, the IMF projected that Cyprus’s economy will not grow for the remainder of 2011 and will shrink slightly in 2012. The IMF also predicted that Cyprus’s fiscal deficit will swell to 7% in 2011, although it should decrease to 4% in 2012. These projections are less optimistic than those of the Cypriot government, which projected 1.5% growth and a 2.3% deficit in 2012.

Cyprus is an island nation in the Mediterranean Sea with a population of one million people and a €17 billion ($23 billion) economy. Aside from its ongoing fiscal deficit, Cyprus has encountered two additional financial difficulties this year. On July 11, a power station explosion caused an estimated €2 billion ($2.7 billion) in damages. Later that month, credit agencies downgraded the country’s bond rating due to Cyprus’s banks’ heavy exposure to Greek debt—a country going through its own debt crisis. The downgrade pushed interest rates on Cypriot bonds up as investors demand a higher yield (interest rate) to compensate them for the higher risk they are taking in purchasing Cypriot bonds. The IMF also recommends Cyprus conduct “stress tests” on its banks to determine whether they have sufficient capital (cash) on hand to cover any losses that would result from various adverse economic scenarios. These tests would give Cyprus a better understanding of the future financial difficulties it may face and would enable the country to prepare accordingly.

Despite Cyprus’s gloomy outlook, there are some positive signs. Cyprus is in the process of finalizing a €2.5 billion ($3.4 billion) loan from Russia at an interest rate of 4.5%, which is much lower than the current rate Cyprus can borrow at on the international bond markets. The loan will allow Cyprus to pay down some of its existing—and higher interest—debt. Furthermore, the discovery of large natural gas deposits in the Mediterranean provides hope for a boost in Cyprus’s economy. However, ongoing disputes with Turkey about Cyprus’s rights to the natural gas threaten to put a halt to drilling efforts.

The IMF cautions that these positive developments should not weaken the government’s resolve to push through austerity measures. Among the IMF’s recommendations for spending cuts are to mandate public sector employees to contribute to their pensions, freezing public sector wages and the cost of living allowance on public pensions, and raising the value-added tax. In line with the IMF’s recommendations, the finance minister’s 2012 draft budget includes a 1,100 person reduction in public sector employment, a €220 million ($299 million) reduction in social spending, and an increase in the value-added tax from 15% to 17%. The finance minister will present this budget to the parliament in mid-October, but given opposing political parties’ opposition, it is unclear whether the budget will pass.

Cyprus may not be the largest or most important economy in the European Union, but unless it takes steps to reduce its growing debt, it may be the next country in need of a bailout.