By Michalis Zaouras on July 02, 2015

A Greek Drama! Not at a good time for Cyprus.

The recent developments in Greece could not have come at a worse time for Cyprus. The economy seems to have started stabilizing after two years of painful adjustments accepted as a part of the bail in agreement with the Troika. The country has at last removed capital controls, even though deposits are still declining.

 Needless to say, that the main reason (and if not the most important) of Cyprus recent financial crisis was triggered by Cypriot banks' exposure to Greece. So, the question now is what will be the impact of the new Greek crisis on Cyprus? The Minister of Finance and the president of Cyprus Central Bank stated that tools and mechanisms are in place that will be used if needed. They have also pointed out that Cypriot banks were required to hedge themselves from those risks.

It is, indeed, a fact that Cypriot banks have reduced their exposure on Greece, even though it is not clear (data are hard to get) what level of exposure remains. But I think the most worrying scenario is what will happen to Greek subsidiaries in Cyprus if their main group in Greece becomes insolvent (a scenario which becomes more likely day by day because of the current bank runs and possibly a further increase on non performing loans).  These banks hold 16% of the deposits in Cyprus (7.74 bn Euro), which might seem small at once (and not systemic to Cyprus). However, we need to have in mind that the size of the financial sector is extremely large relative to the Cypriot economy. When we take that in consideration then this number corresponds to 44% of GDP!

Greek banks remaining solvent is still the most likely scenario (for now at least). But I strongly believe that the threats to the Cypriot economy are real, whether this comes from Greek banks' subsidiaries or negative externalities from a deeper recession in Greece or even contagion. I also believe that the timing is, unfortunately, extremely bad for Cyprus. The few positive signs of recovery can easily be reversed.