In mid-2007, Cyprus qualified for eurozone membership by meeting the stringent Maastricht criteria, intended to ensure that new entrants would behave responsibly and flourish in the secure environment provided by the currency union. In the months leading up to the decision, the IMF urged Cyprus to take all necessary steps to ensure a favorable outcome.

The benefits of Cyprus's adoption of the euro may never be clear. By 2009, the IMF's Article IV Staff Report was already ringing the alarm bells. Public debt was still low, but growing rapidly, the current-account deficit was ballooning (reaching 15 percent of GDP in 2008) and the banks had gone Icelandic, with assets worth more than three times Cyprus's GDP. As the report noted, the huge and highly concentrated banking sector's problems could "quickly escalate to systemic proportions with serious economic repercussions." And so they have.

This is a remarkable outcome, given that the risks have been so well known and understood. Indeed, the Cypriot authorities have been engaged in ongoing discussions with the troika (EC, ECB and IMF) for the past year. And yet, despite all the preparation, a night of closed-door negotiations led to a stunningly elementary error.

Compounding that error was the absence of any substantive decision concerning how to extricate Cyprus from its downward spiral. Cypriot debt, we are told, will rise to 140 percent of GDP, and will fall to about 100 percent of GDP in less than a decade. This appears to be another replay of the Greek scenario, with targets for reducing the debt burden repeatedly missed, until more drastic steps become inevitable.

Most importantly, no restructuring of Cypriot banks appears imminent. On the contrary, the intent seems to be to keep large depositors from fleeing and preserve the highly risky system. The Central Bank of Cyprus has provided large loans to Cypriot banks under the Emergency Liquidity Assistance arrangement, implying that the collateral offered did not meet the standards of the ECB. More train wrecks are in the making.

The problems in Cyprus now threaten international financial stability. If the idea of a European banking union is serious, now is the time to advance it. That means reaffirming the commitment to deposit insurance, closing unviable banks and recapitalizing the rest with European (not Cypriot) funds.

The troika's decision on Cyprus was akin to policymaking by rolling the dice. The coming days will reveal the extent of the immediate damage that it has caused. But, with another display of reactive and ad hoc decision-making, we are no wiser about how Europe intends to resolve its dilemmas. Could the Cypriot setback catalyze a fresh start?

The author is visiting professor of International Economic Policy at the Woodrow Wilson School of Public and International Affairs, Princeton University, and a former mission chief for Germany and Ireland at the International Monetary Fund.

Project Syndicate

(China Daily 04/01/2013 page9)