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A public policy blog from AEI
There can be little doubt that the Cypriot economy will implode in the period immediately ahead as the banking business model on which its economy was largely based has been shattered. In those circumstances, Cyprus would have been well advised to exit the Euro and to adopt its own currency. This would have afforded Cyprus the ability to use currency devaluation as the means to provide an immediate competitive boost to its tourist sector, which now needs to take on the role from the banking sector as the main driver of the Cypriot economy. A boost to the tourist sector would also have been most timely in that it would have provided a cushion to the adverse effects on the Cypriot economy of IMF imposed fiscal austerity.
While Cyprus could very well choose to exit the Euro at a later stage, there are several reasons to regret that it did not choose to do so now. First, one would have thought that with a bank holiday and severe capital controls already in place in Cyprus, now would have been the ideal time for Cyprus to have introduced a new currency. A principal reason why countries in the European periphery shy away from exiting the Euro is that they do not want the disruption of bank holidays and capital controls that are associated with such a move. This does not apply to Cyprus where a bank holiday and capital controls are already in place as part of its bank restructuring program.
A second reason to regret that Cyprus did not introduce its own currency now is that its government still has the political capital needed to introduce a new currency. In particular, it would have been able to back the new currency with an appropriately restrictive budget policy. In the months ahead, as the economic recession deepens, it is far from clear that the government will retain the political capital that it still now has which will make Cyprus’ Euro exit at that stage all the more difficult.
Yet a third reason to regret that Cyprus did not exit the Euro now is that currency devaluations take time to boost exports and the tourist sector. One would have thought that with the supply-side shock from the collapse of its banking that Cyprus is now suffering, the Cypriot government would have realized that there is no time to be lost in taking measures that offered a realistic hope of boosting tourism and exports soon.
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