Cyprus: The Tail Wagging the European Dog

Bank closures and account forfeitures in Cyprus have reignited fears of a European economic collapse, however the relatively small size of Cyprus’ economy and bailout mean this latest EU crisis is unlikely to have such dire consequences.

Cyprus is one of the smallest economies in Europe, its GDP was approximately USD25 billion in 2012 or less than 0.2% of European Union (EU) national output. The size of the bailout required was only a fraction of the size of previous bailouts that have occurred in Europe (see diagram below) and could easily have been absorbed by the European Central Bank (ECB) or the International Monetary Fund (IMF).

The Cypriot financial crisis does however raise a number of important and interesting questions. How did the crisis actually develop? Why did such a small nation’s plight have such a large impact on world markets? And what is the significance of the new ‘bail in’ method to dealing with insolvent financial systems?

Cyprus the Tail Wagging the European Dog1

How did the Crisis Develop?

Just a month after being elected, the new President of Cyprus Nicos Anastasiades attended his first EU summit in Brussels in the Belgian King’s palace. The Cypriot bailout was a major and contentious issue. German finance Minister Wolfgang Schaeuble had gone to Brussels with a firm mandate from Berlin: “no bail-in, no bailout”. European officials set on a figure of 5.8 billion to come from depositors. Cyprus had approximately 30 billion in insured deposits and about 38 billion in uninsured deposits. An unusually large amount for a country of one million people. Due to Cyprus’ status as a tax haven Cypriot bank assets had reached eight times the level of national output.

Cyprus could have offered full protection to those with insured deposits up to 100,000 and still reached the 5.8 billion target by taxing uninsured deposits. ECB board member Joerg Asmussen and Euro zone finance ministers’ representative Thomas Wieser had worked on a plan that would require just that. But when the plans were presented to Cypriot President Anastasiades he balked at any suggestion that uninsured depositors should pay more than 10%. Since his limit meant uninsured depositors would pay no more than 3.8 billion, small savers in Cyprus would be forced to pay a levy as high as 6.75% of their deposits. In violation of the policy of depositors being insured up to 100,000.

When details of the proposed solution were leaked the opposition in Cyprus labeled the deal “bank robbery” and there was widespread peaceful protest. The picture below makes it clear who the Cypriot people blamed. Eventually the deal was knocked back by the Parliament of Cyprus. The damage was already done, financial markets had been spooked and the EU and the Cypriot President’s reputation had suffered.

Cyprus the Tail Wagging the European Dog2

The Current Situation “Bail In”

The current plan to go before the Cypriot Parliament in April is outlined in the diagram below.  Essentially the plan involves the recapitalization of the nation’s largest banks. Cyprus’ second largest lender, Cyprus Popular Bank, also known as Laiki, is to be shut down, and accounts of under €100,000 and some loans will be moved to the Bank of Cyprus. Deposits at both banks over the €100,000 mark, which is the EU benchmark for state insurance, will be frozen.

Government officials have estimated that these larger depositors, many of them wealthy foreigners including Russians, could lose around 40% of their cash. The process, known as a “bail-in” sees 37.5% of deposits exceeding €100,000 converted into equity in the Cyprus Popular Bank, and an additional 22.5% used as a buffer which could also be converted into equity if circumstances warrant it.

Cyprus the Tail Wagging the European Dog3

Why does it Matter?

Given the relatively small size of the Cypriot economy, why does the Cypriot crisis matter? One major reason is to do with the method in which it has been dealt with. The new “bail in “ approach as oppose to the “bail out” approach has sent shivers of panic through many European depositors. It is the first time that this method of dealing with an insolvent banking system had been floated. What made it especially concerning to European depositors was the fact that the Troika of the European Commission, the ECB and the IMF were considering inflicting losses on insured deposits. This was previously unheard of, although many now blame this course of action squarely on Anastasiades shoulders claiming he was willing to sacrifice the life savings of ordinary Cypriot citizens to protect the assets of wealthy foreign depositors.

This actually may go to the heart of why the Troika opted for the bail-in option in the first place. The Cypriot banking system had grown to become approximately 8 times the size of GDP, and according to estimates by RBS Morgans economist Michael Knox, 40% of Cypriot bank deposits were foreign, of which about 60% were Russian (not a member of the EU). It is assumed that much of this is from dubious origins and EU taxpayers have been understandably reluctant to fund the rescue of a financial system bloated on Russian oligarch savings.

Another reason the Cypriot financial crisis matters is contagion. Other nations in the EU with bloated banking systems include Luxembourg, Malta, Slovakia and Slovenia. Fears that they may suffer the same fate as Cyprus have shaken confidence in the EU. These countries are seen as vulnerable, the graph below shows the size of the total non-banking deposits compared to GDP in the EU.

Cyprus the Tail Wagging the European Dog4

Contagion fears spooked financial markets around the world following news of the Cypriot financial crisis. The graph below shows the direction of European bank shares after news of the bailout was released. Stock markets around the world were also affected with the ASX 200 falling below 5000 for the first time in a month.

Cyprus the Tail Wagging the European Dog5

Conclusion

The major impact of the Cypriot financial crisis has been the damage done to global confidence in the EU’s capacity to deal with another financial crisis. The idea the Troika would consider raiding government guaranteed deposits to prop up a failing banking sector damaged their reputation and shook global confidence in their institutions.

The raid on deposits will also have a lasting impact on European’s confidence in the safety of banks in general. Reports are now being made EU citizens are beginning to accumulate cash outside the banking system, especially in countries such as Greece, Italy, Spain and Portugal where austerity measures are still in place and economic growth is low or negative. This lack of confidence will be long lasting and given the high debt levels in Europe it is only a matter of time before another crisis hits.  When it does the world’s financial markets will be closely scrutinizing how it is deal with.

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