One has to pity Cyprus. It is all but certain to experience an economic collapse over the next year or two at least on the scale of that recently experienced in Greece. Cyprus is being subjected by its European partners to the same recipe of severe fiscal austerity within a euro straitjacket that produced an economic depression in Greece. It cannot devalue its currency as a means to boost its tourist sector, and must also cope with the imminent collapse of its financial sector, which is overly dependent on catering to Russian depositors.

The origins of Cyprus’s dire economic and financial situation can be traced to a lack of adequate supervision of its financial sector. Fueled by an influx of money from Russians seeking a tax haven, the Cypriot banking system was allowed to grow to eight times the size of the Cypriot economy. Compounding the economy’s vulnerability, Cypriot banks managed to invest the equivalent of 160 percent of Cyprus’s GDP in Greek government bonds. When the Greek government defaulted on its bonds, the Cypriot banks experienced a capital shortfall estimated at close to €9 billion, the equivalent of approximately half of Cyprus’s GDP.

The decision by Cyprus’s European partners to force Cyprus to bail-in its large depositors as a condition for an International Monetary Fund–European Union rescue package is almost certain to have killed Cyprus’s attraction as an offshore tax haven, especially to Russians. After being subjected to a 40 percent write-down of their bank deposits and strict capital controls on withdrawing their remaining deposits, Russians surely will have lost all confidence in Cyprus as a financial center. This will make them want to move their money out of Cyprus at the earliest opportunity, which is almost certain to result in a dramatic scaling down of Cyprus’s banking sector and its employees.

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