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Cypriot bailout assumptions aren’t realistic

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The economic assumptions behind the Cyprus bailout look too optimistic. The official lenders, which will advance €10-billion ($13-billion) to the stricken state are counting on a hefty drop in domestic GDP over the next few years. But they may well be underestimating the economic catastrophe.

A leaked version of the latest memorandum of understanding between Nicosia and the entities bailing it out envisages a 2014 primary deficit – the difference between revenue and spending before debt servicing – of €678-million or 4.3 per cent of GDP. That implies total GDP of almost €16-billion, 11 per cent lower than the €17.9-billion euros most recently stated.

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A big fall is inevitable. The government's overall package of fiscal consolidation measures will total 7.25 per cent of GDP by 2016, and taxes and the price of state services are rising.

But how big will the fall be? In neighbouring – and similarly overexpanded – Greece, the shift from good times to fearful austerity has led to a 20-per-cent GDP decline over four years, according to Morgan Stanley estimates. If anything, Cyprus looks worse. Greeks didn't have to contend with "temporary" capital controls, which will gum up business and dampen confidence. And the decision to haircut uninsured depositors in the biggest Cypriot banks will severely undermine its financial sector.

That matters, because finance contributed 9.2 per cent of Cyprus's gross value added in 2012, almost twice the euro zone average. Between 2000 and 2008 services exports, much of them related to the finance trade, accounted on average for 42 per cent of GDP, against 8 per cent in the wider euro zone. A big chunk of business came from Russians, who will be wary after large writeoffs.

A more-than-Greek contraction in double-quick time is possible. Morgan Stanley reckons that a 20-per-cent dip would push the ratio of Cypriot debt to GDP to 120 per cent by 2016, the same year that Cyprus is supposed to refinance a €2.5-billion loan from Russia. Gas reserves could help, but seven-year Cypriot sovereign debt is now selling at 65 per cent of par. Investors are factoring in a big risk that it will all go wrong.

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