The short-term problems facing Cyprus seem quite daunting but they pale into insignificance when compared to the likely long-term domino effect that will undermine trust in the Cypriot economic model. What is happening in Cyprus is an eye opener for small States.

What is happening in Cyprus is an eye opener for small States

When Cyprus joined the EU in 2004 it was the darling of economic and business analysts. Here we had a small island, a former British colony invaded by Turkey in 1974, that in the span of a few years reinvented itself moving away from a military economy to one based on tourism. The next step in their development was equally successful. Cyprus soon built a formidable financial services sector by exploiting its strong banking credentials based on conservative British practices.

As Jan Strupczewski of Reuters writes, up to 2010 “there was no official red flag that Cyprus’s oversized banking sector posed a big risk to the economy. When Cyprus was examined as to whether it met the criteria to join the European Union in 2003, a European Commission report on its readiness mentioned no problems with the banking sector – it was not a criterion for membership.”

Neither did the European Central Bank mention that anything was wrong with the Cypriot banks or their business model when it evaluated whether Cyprus was fit to join the eurozone in a 2007 report. It seems that economic analysts are not very good at foreseeing risks in economic models that are designed in an academic environment. I have always believed that the worst risk is the risk that you do not know much about.

According to Reuters, “the first public mention of the threat that Cypriot banks might pose to the financial stability of the island” was first made in a report published in 2012 by the European Commission.

Every economist is aware of unidentified risks when trying to evaluate any particular economic strategy. Crystal ball gazing is no science and only fools can claim that they are capable of identifying all the risks that could throw an economy off the rails. We often have to rely on intuition because economic forecasting is not an exact science. And we all know how intuition can often let us down

I remember colleagues arguing some years ago that a eurozone country could never face bankruptcy because “the beauty of the euro club is that if one country faced difficulties, all the others would move in to rescue it”. These same people often failed to understand concerns about mushrooming sovereign debt in some eurozone countries. Some foolishly believed that a government in distress could just increase taxation when the servicing of its debt became too onerous.

Whether they like it or not, the Cypriots will have to change their economic model. Trust is a very fragile intangible asset. No country can expect to have a viable financial services sector when measures are taken that shatter trust in the financial system.

While EU economists and policymakers were unable to see the crisis coming, and even less able to do something about it, they will now certainly insist that Cyprus reduces its financial services sector to more acceptable levels – probably with total banking assets not exceeding 3.5 times of GDP.

Rating agencies have for long identified concentration risk in our own economic model. As long as one particular sector of the economy accounts for a substantial part of our GDP, it will pose a concentration risk that needs to be managed.

This does not imply that we should put artificial barriers to further growth on these sectors. However, we will need to work harder to promote growth in other areas that may be struggling to attract sufficient investment for renewal.

The best economic strategies are often defined not in a time of crisis when a country is with its back against the wall, but in times of relative calm when one can still use the brakes to reduce exuberant growth in one economic sector and press the accelerator to stimulate higher growth in sluggish sectors.

In the past decade some of our traditional economic activities like tourism and manufacturing have been starved of significant new investment and are now struggling to perform well. New economic activities have not been very visible recently and more needs to be done to encourage investment in new areas like that of maritime services.

The time is definitely right to put diversification at the centre of our economic strategy.

johncassarwhite@yahoo.com