By Jan Strupczewski
BRUSSELS (Reuters) - Cyprus's bank restructuring, a condition for international aid it needed to stave off bankruptcy, will force the Mediterranean island to scramble for new ways to generate wealth.
If it fails, international lenders may have to do what they wanted to avoid and which Germany and its northern European allies may baulk at - give Cyprus more money.
Nicosia will get 10 billion euros ($13 billion) over three years from the euro zone and the International Monetary Fund. In return, it will halve its dominant banking sector and hit large depositors to help recapitalize what is left of it.
Because financial services played a vital role in the island's economy - accounting for 9.2 percent of GDP and 5.1 percent of jobs in 2012 according to EU statistics service Eurostat - the fallout will deliver a devastating blow.
Deficit targets agreed between the euro zone and Cyprus in a memorandum of understanding imply that the economy will contract almost 8 percent this year and another 3 percent in 2014.
It is forecast to return to growth in 2015, a view some economists see as optimistic.
"The nature of the rescue has made things worse. That already makes me think if, like in Greece, we will have a series of revisions to growth and therefore to the financing needs of the country," said Nick Kounis, economist at ABN Amro.
Greece has been bailed out twice by the euro zone and IMF since 2010 after projections for debt-cutting and a return to growth consistently proved too optimistic.
The euro zone argued it could not lend Nicosia additional money to recapitalize its oversized banking sector, because Cyprus will not be able to repay more than 10 billion euros.
Apart from the direct impact on GDP from winding down the second biggest bank Laiki, and the destruction of a banking model designed to lure funds from abroad, the economy will suffer from a ripple effect across related industries, especially tourism.
Added to that there is the impact of more than a week of unplanned bank holidays and a confidence shock among consumers and investors to factor in.
"The outlook for the Cyprus economy is very bad," said Christoph Weil, economist at Commerzbank. "I see no new model for the economy, I would expect Cypriot GDP to shrink in 3 years by more than 10 percent," he said.
"Investors will not come back to Cyprus in the coming years because of the bank experience, I don't now anyone who would give Cypriot banks new money and that will not change in the coming years," he said.
That could have implications beyond Cypriot borders.
The head of Greece's biggest business group said on Wednesday that the Cyprus crisis could tip Greece into an even deeper recession this year.
"Greece is directly affected by the Cyprus crisis and based on some estimates this may chop up to one percentage point off GDP," Dimitris Daskalopoulos, head of the Hellenic Federation of Enterprises (SEB), told reporters.
Greece's economy is in its sixth straight year of decline as Athens applies bailout-imposed austerity policies which have pushed unemployment above 26 percent, the highest rate in the 17-nation euro zone.
That experience puts a big question mark over the prediction that Cyprus will return to growth in two years' time.
Recognizing the size of the challenge, the European Commission is putting together a special task force to come up with new ideas to help the Cyprus economy, as it did for Greece.
Yet even more damage to growth comes with every day of capital controls, imposed by the government last week to stop money flowing out of the island.
"The major fear is that the Cypriot banking system will not be able to be a proper financial intermediary to the economy, which would have an additional downward impact on growth," said Zsolt Darvas, economist at the Bruegel think tank.
The Cypriot economy relies mainly on services, as manufacturing accounts for around 6 percent of gross domestic product, agriculture for some 2.3 percent and construction makes up 6.2 percent.
Transport, restaurants, hotels and shops produce 23 percent of the country's wealth and employ a third of the workforce and another 22 percent comes from public administration, defense, health and education. The real estate sector provides a further 11.6 percent.
Cyprus has also found natural gas off its cost and once the deposits are documented, the island can build an industry around gas exports. But these are more medium-term plans with estimates that it will not come onstream before 2018 at the earliest.
WHERE'S THE GROWTH?
None of these sectors appears able to grow quickly enough to replace the missing contribution from financial services, although Cyprus and its international lenders believe tourism has the best shot and will prepare a study on how to make it more attractive.
Yet even there, economists point to strong competition for tourists from Greece and Turkey in the region and in the end, growth needs investment and investment needs confidence.
"Just the uncertainty about the future tends to be a killer in terms of activity," said ABN Amro's Kounis. "Who is going to invest in Cyprus now?"
Some economists believe that Cyprus will still be in recession in 2015 and possibly longer, raising the question of new loans for Nicosia, on top of the agreed 10 billion -- precisely what the euro zone wanted to avoid.
"If the growth assumptions are wrong and the demise of the financial industry has a bigger effect and growth does not pick up, there is a risk of second round negotiations with more money to be thrown at Cyprus," said Gilles Moec, economist at Deutsche Bank.
One senior euro zone official involved in the preparation of the Cyprus bailout said the assumptions for the program were sufficiently pessimistic for now.
"Everybody wanted a program that is sufficiently credible from the start, that will not have to be revised every six months, for now the program still holds," the official said.
($1 = 0.7789 euros)
(Reporting By Jan Strupczewski, editing by Mike Peacock)