Cyprus' fate is linked to the challenges facing the Eurozone
The Cypriot economy is undoubtedly facing serious structural problems. Τhe key to overcoming the crisis lies in fiscal rationalization, bank recapitalization, reform of the financial sector and the further diversification of the economy with the development of new engines for growth. Overcoming the challenges requires new approaches domestically as well as the support and the solidarity of the EU. However, the Eurogroup, amidst a political power struggle among member states and EU institutions, a series of internal electoral contests and with a new head in Dutch Finance minister Jeroen Dijsselbloem – a labeled conservative and a proponent of strict fiscal discipline – is pursuing policies that may create problems for the stability of the Eurozone as a whole.
Cyprus is currently under considerable stress. The due diligence exercise by PIMCO has concluded that the requirements for bank recapitalization range around €9 billion. If this is added to public debt it would have the consequence of rendering it unsustainable. Hence, it will be essential to consider other arrangements; this may mean that bank capitalization, at least partly, should be directly from the European Stability Mechanism (ESM). Cyprus is also under sustained scrutiny for money laundering and has recently come under severe criticism on the matter. This would need to be handled delicately on the one hand to confirm compliance but on the other, not to jeopardize investor confidence in the confidentiality of our banking system.
The debt crisis and the broader economic crisis have raised several issues, including those of fiscal consolidation and solidarity among EU member states. The Union may have to revisit some fundamental economic principles. A policy of containing budget deficits and encouraging rationalization of public spending is in principle correct. But trying to maintain balanced annual budgets irrespective of the economic circumstances of a country would, most likely, create more problems than it could solve. Indeed during a recession such an approach is pro-cyclical and would worsen economic conditions, even lead to depression. The case of Greece may well be an indicator.
A similar rationale is being adopted in the case of Cyprus. With unemployment already at 15%, instead of following growth oriented policies the overriding objective appears to be locked on fiscal consolidation and deficit reduction. A new approach would allow states to aim for a balanced budget on the basis of an average over an extended period of time (such as five years for instance). This would permit a discretionary expansionary fiscal policy in times of recession or crisis, and would encourage growth.
Furthermore, it is of utmost importance to move forward to establish a fully-fledged fiscal union. EU spending will also have to increase considerably from currently 1% to about 3% of the total GDP of the Union. This will enable the Union to support member states when in need with targeted spending. Understandably, for the implementation of this policy option it is also essential to reach a consensus for closer integration. This entails greater solidarity, as well as a departure from the current wrangling at the Council, Eurogroup and ECOFIN levels by heads of member states that wish to appease voters in their own countries. At the same time it will also ensure greater commitment by member states to move forward with the necessary reforms for fiscal consolidation and a greater degree of integration.
Obviously the issues under consideration require a paradigm shift. It is questionable whether in the long run there can be a monetary union without a fiscal union. Recent discussions for a Banking Union constitute a step in the right direction. Moreover, fiscal federalism can offset the effects of asymmetric shocks and policy wars that hinder the decision process – especially at times of need. The transfer of more fiscal responsibility from the national level to a common Eurozone authority seems to be necessary for the viability of the monetary union but difficult to achieve. Some analysts go even further and support that a common currency can only exist within the framework of a political union. These issues deserve to be addressed quickly and with an open mind.