Salmon: Why Cyprus Must Leave the Euro

NEW YORK ( Reuters Blogs) -- Megan Greene has a great column on Cyprus and the euro today. In short, there are costs and benefits to leaving the euro -- but the costs are going to be borne anyway, which means that at the margin, devaluation is likely to be good for the country.

Among the greatest costs of any euro-area exit would be bank defaults on their liabilities, capital controls and a sovereign default. Cyprus has already experienced the first two and will most likely see the latter in the next year or two if it stays in the euro area.

So if Cyprus is going to incur some of the worst costs of abandoning the euro anyhow, it might as well print its own currency and benefit from a devaluation and the immediate boost in competitiveness that would follow.

This is perfectly logical. But -- you knew there was going to be a but -- there are two big complications.

Firstly, leaving the euro is an expensive proposition, and Cyprus doesn't have any money: It's already selling off its gold reserves to help recapitalize its banks. Cyprus would be insolvent, with massive new debts to the ECB; it would also have massive liquidity problems, with no obvious way of paying for the enormous quantities of foreign imports all island nations require. As a result, there's only one way for Cyprus to exit and devalue without risking power cuts, food shortages, and general chaos: It would need to borrow even more money than it has done already. Which is not going to be easy, given that the rest of the world has made it very clear that it's pretty much maxed out, in terms of loans to Cyprus.

How could Cyprus persuade the EU and the IMF to lend it the extra money it would need for a semi-orderly devaluation? Threatening default wouldn't work since it's basically impossible for Cyprus to devalue without defaulting. Alternatively, it could threaten to run into the arms of Russia, but that would be a very high-risk strategy indeed.

And then there's the other big complication: While a Cypriot exit would probably be good for Cyprus, it would be very bad for the rest of the eurozone since it would be a clear precedent showing that exiting the euro is possible after all. The result would be further capital flight from the eurozone periphery towards the center, and a general feeling that the multi-year project of trying to remove tail risk from the euro had failed spectacularly. There's no way that any country leaving the euro could possibly be good for the rest of the currency union -- even if that country were as small as Cyprus.

Greene's conclusion, then, is absolutely right: If the troika won't help Cyprus exit the euro -- and there's absolutely no indication that it will -- then "Cypriots really are stuck." The government would have no recourse, at that point. Individual citizens, on the other hand, could still take advantage of the relatively free labor mobility within the EU and move to another European country where prospects are brighter.

Is that likely? Even within countries, people in poorer areas (the north of England, the south of Italy, the east of Germany) rarely move en masse to richer areas with greater potential; big movements between countries are rarer still. But the bigger the osmotic gradient between two economies, the greater the flow of human resources into the wealthier nation. And Cyprus has more than its fair share of the most mobile population in Europe: relatively young and well-educated people with good language skills. If their future is brighter in the UK than it is in Cyprus, they'll move there.

Cyprus can implement capital controls, but it can't implement emigration controls. Even if it does leave the euro, a lot of its most talented professionals will leave; if it doesn't, and falls instead into what Greene calls "an endless spiral of austerity and recession," the brain drain will make Latvia's look modest. The cost of joining the euro, for Cyprus, will be no less than a hollowing out of its population, along with its economic and demographic future. Let's hope that it manages to find a way to exit, somehow.

-- Written by Felix Salmon in New York.

Read more of Felix's blogs at Reuters.