NICOSIA (Reuters) - Any escalation in the Ukraine crisis poses a threat to Cyprus's economy, the outgoing governor of the country's central bank said in an interview, noting that he expects the bailed-out euro zone member to return to growth in 2015.
Panicos Demetriades, who participated in talks which saved Cyprus from bankruptcy a year ago, said lenders underestimated the resilience of the island's economy, one of the smallest in the 17-member currency zone. He also said he anticipated capital controls could be fully lifted this year.
Cyprus is receiving 10 billion euros ($14 billion) in aid from a troika of lenders: the International Monetary Fund (IMF), the European Central Bank and the European Commission.
In March 2013 it was forced to wind down Laiki, Cyprus's No. 2 lender, and convert a sizeable portion of large deposits into equity at market leader Bank of Cyprus. The "bail-in" occurred after IMF debt sustainability analysis determined the country could not afford debt exceeding 100 percent of its GDP.
"In hindsight, data shows that they (the IMF) could have used a higher benchmark of debt to GDP which would have limited the bail-in," said Demetriades, who steps down in early April.
Had lenders used a benchmark of 120 percent, an additional 3.6 billion euros could have been made available, restricting the bail-in of depositors to one bank instead of two.
It was the first time Demetriades had said he had disagreed with the IMF's assumptions. He said the IMF was "challenged" on the matter, but "never moved from their position".
"This would have limited the shock to confidence and would have made it easier for Cyprus to recover. Although, not withstanding the big shock, we are already showing early signs of recovery," Demetriades told Reuters.
Cyprus's economy contracted by 5.4 percent in 2013, significantly lower than initial lenders' projections of an 8.7 percent drop in output. They forecast a further 4.8 percent dip in 2014 before returning to growth in 2015.
A more competitive climate with the reduction of labour costs and resilience in tourism, shipping and the broader services sector would support the return to growth, he said.
Any deepening of the crisis between Moscow and the West after Russia's annexation of Crimea, could temper that outlook, Demetriades said. Russia has many links with Cyprus, and one of the fastest-growing markets for tourism.
"It certainly has risks to Cyprus if it escalates ... through services, tourism because of the depreciation of the rouble, but also in general in terms of creating uncertainty."
Demetriades declined say why he was resigning. In May he returns to the University of Leicester where he taught economics before taking office in May 2012.
Authorities are gradually easing currency controls imposed last year to prevent a flight of capital after the bail-ins.
"Short-term deposits by foreign residents have increased, deposits are stabilising in general," Demetriades said, noting that once or twice a month Cypriots ask the bank to replace damaged banknotes they have stored in ovens or washing machines.
On March 28, the Cypriot finance ministry scrapped a daily cash withdrawal limit in place for a year, though full easing of controls on cash transfers abroad is expected to take longer.
Asked when he believed controls would be fully lifted, Demetriades said: "If Cyprus continues to successfully implement reforms as set out in the programme, I expect it could happen by the end of 2014."
(Editing by Louise Ireland)