ATHENS — After a chaotic month in which Cyprus was pushed to the brink of default and a possible exit from the euro zone, Cypriots knew things would get bad. But not this bad.

According to a bleak assessment released Thursday by its European partners, Cyprus will fall into a downward spiral for at least the next two years, with the economy contracting up to 12.5 percent over the period as the country prunes back a dangerously outsize banking sector that had ballooned to more than five times gross domestic product.

And because the economy will do worse than expected, Cyprus must soon raise €13 billion — nearly twice the amount the government thought it would have to come up with just a month ago — in order to keep its debt and deficit from spinning out of control and to meet the terms of a desperately needed €10 billion, or $13.1 billion, international bailout secured last month by the newly elected president, Nicos Anastasiades.

A shrinking economy means the country’s budget deficits are likely to grow, so the government will need to raise more money to keep the deficits within limits set out under its bailout agreement. Because the government has also committed to improving the health of its banks, it must come up with yet more money to ensure that the lenders have adequate capital, particularly critical if their loan losses start to snowball as the economy slumps.

“In the short run, the economic outlook remains challenging,” the European Commission said in the report, which details the conditions that the Cypriot government agreed to meet in order to obtain the financial lifeline from the so-called troika: the International Monetary Fund, the European Central Bank and the commission.

So strapped is Cyprus that it has agreed to sell its prized assets to raise money. Chief among them is part of the gold reserves held by the central bank. In what would be the first such sale by a central bank in the euro zone, Cyprus had already agreed to sell €400 million worth of gold, or an estimated 10 tons from its 13-ton stash.

Cyprus’s coffers have run dry as it scrambles to keep its banks from collapsing. On Tuesday, the newly appointed finance minister, Harris Georgiades, said that without the bailout, public funds would run out by the end of April.

Cyprus is under pressure from the troika to speed development of the natural gas reserves that have been discovered off its coast. The hope, as stated in the commission’s assessment, is that the proceeds would be used to keep Cyprus’s debt under control as the economy slumps.

But this could set off a hornet’s nest of geopolitical tension. Turkey, which occupies the north of Cyprus, last month challenged any move by the nation to speed exploration, especially if it means Russian involvement. Turkey warned that it may “act against such initiatives if necessary.”

In the meantime, the commission described a bleak future for Cyprus, at least in the short term.

The nation was required to fold part of its second-largest financial institution, Laiki Bank, known also as Cyprus Popular Bank, into the largest, the Bank of Cyprus, under the terms of the bailout. Numerous companies of all sizes are likely to go shut down as banks cut back on issuing credit. Other lucrative businesses that fed off the bloated financial services industry in Cyprus are also likely to suffer. Real estate prices, which have already begun to fall as a property bubble collapses, are expected to deteriorate further.

Company registered in Cyprus, even as a simple mailing address, are likely to look elsewhere as the corporate tax rises to 12.5 percent from 10 percent. That is still the lowest rate in the euro zone next to Ireland, but it removes one big draw for the country.

Meanwhile, the commission continued in its report, people and businesses that held uninsured deposits at the two largest banks will see a “loss of wealth” as the government takes the unprecedented step of confiscating up to 60 percent of their funds to meet the terms of the bailout deal.

That, combined with extraordinary restrictions on withdrawals in order to prevent a bank run, will in turn cut down on consumption and business investment, the commission added. That will further scar an economy that had already started to slow two years ago as Europe’s long-running debt crisis set in.

Analysts say that once the restrictions are lifted, people are likely to take their money out of Cypriot banks en masse, since few believe the government’s promise that the bank levy being imposed now will be a one-time measure.

A fresh scandal blew through the halls of power this week when the central bank sent a report to Parliament showing that 6,000 people had withdrawn large sums of cash from Cypriot banks in the two weeks leading up to the island’s first bailout agreement. That deal fell apart after the government and European leaders temporarily agreed to a plan that would have confiscated savers’ insured deposits to help Cyprus raise the money its creditors required in exchange for the bailout.

Cypriot banks, already near collapse because of losses from bad loans made mostly in crisis-wracked Greece, as well as losses from holdings of Greek government bonds, could come under new strain, the commission warned, as loans to businesses and individuals start to sour along with the economy.

Unemployment is already near 15 percent and is expected to surge as the financial industry winds down. In the meantime, efforts to recast the economy to lean more heavily on tourism will probably take years.

The report concluded that the only real hopes for the moment seemed to be to drill for natural gas, or for the overall European economy to turn around.

Article source: http://www.nytimes.com/2013/04/12/business/global/cyprus-bailout-to-cost-more-than-predicted-creditors-say.html?partner=rss&emc=rss