Cyprus: How Bad Is It?

Cyprus Financial Crisis

Europe’s answer to an insolvency crisis in Cyprus surprised market watchers by insisting that bank depositors large and small pay hefty one-time taxes on their deposits in order for the country to qualify for a bailout.

 

A further surprise came when Cypriot lawmakers rejected the painful solution, which would have raised €5.8 billion from account holders in exchange for a €10 billion bailout to keep the country’s ailing banks and government running.

 

The events produced more questions than they answered: Would Cypriot politicians or European officials come up with a viable alternative to the bailout terms? Could Europe’s proposed solution trigger wider doubts about the safety of deposits in other ailing peripheral countries such as Portugal, Ireland and Spain?

 

And perhaps most serious of all: Could the tough bailout terms – and their rejection – be the catalyst to Cyprus leaving the European Union and reigniting global fears about that body’s dissolution?

 

Initial terms from the European Union and International Monetary Fund called for a 6.75 percent tax on all deposits below €100,000 and a 9.99 percent tax on larger amounts. The collections would be worth 33 percent of Cyprus’ GDP, and along with several other measures such as privatizing state-owned companies, tax increases and a bail-in of junior bondholders, would lower the necessary bailout from €17 billion to €10 billion, according to a recent note entitled “Cyprus Bailout: Raising the Stakes” authored by Credit Suisse Europe analyst Yiagos Alexopoulos and Credit Suisse Head of European Economics Neville Hill.

 

President Nicos Anastasiades unsuccessfully proposed modifying the rescue terms so that smaller depositors with less than €20,000 would not be harmed.

 

The levy on depositors below the €100,000 mark alone would squeeze the economy by the equivalent of 10 percent of GDP, Alexopoulos and Hill said. Under those conditions, on top of previously agreed-upon cuts, the country would be lucky to see growth contract by only 3.5 percent this year, he said.

 

Still, news of the bailout terms immediately triggered concerns about other peripheral countries and financial markets. Moody’s said the move “signals euro area policy makers’ willingness to risk triggering wider financial market disruptions in pursuit of other policy goals,” according to the New York Times.

 

“The most obvious source of contagion would be through the banking sector, where the precedent the decision in Cyprus sets could weaken confidence in vulnerable institutions in other countries,” Alexopoulos and Hill wrote.

 

But Alexopoulos and Hill said the risk of large withdrawals in other European countries with fragile banking sectors may not be as pronounced as some might think. He noted that bank-related bailouts in Ireland, Spain and Greece are further along, and that some particularities of Cyprus’ banking sector, such as the large proportion of deposits believed to belong to Russian citizens, could mean that depositors elsewhere will see Cyprus’ situation as unique. But the move still sets a worrisome precedent for what the EU is willing to ask from countries that need help.

 

“In the longer term, the precedent set by this move, particularly by affecting deposits below the €100,000 insurance limits, may render some of these financial sectors more vulnerable if further capital injections as part of an EU rescue package were seen to become necessary,” they wrote, noting that the risk would apply more to Spain than to Ireland.

 

Russia may also face significant impacts, as Credit Suisse estimates that the bulk of the €32 billion in Cypriot bank deposits that belong to non-European residents come from Russia. European officials were openly wary about taking any action that could be seen as rescuing Russian depositors.

 

Russian officials said they were not consulted on the bailout terms, and President Vladimir Putin called the decision “unfair, unprofessional and dangerous.” Officials said Russia would have been willing to relax the terms on an earlier loan to Cyprus.

 

Cypriot banks will reportedly be closed until Thursday to avoid a bank run, but there have already been reports about citizens emptying out cash machines.

 

“The decision on depositor haircuts comes with the risk of significant outflows from Cyprus,” Alexopoulos and Hill wrote. “With the trust in the banking and political system presumably seriously hit, it is not hard to see such a scenario…We consider it possible that depositors fearing another haircut and/or because of the apparent lack of an EU deposit guarantee might be prompted to remove their funds, exacerbating the financial predicament of Cypriot banks.”

 

But perhaps the biggest risk, Alexopoulos and Hill said, is further antipathy toward the EU in yet another European country.

 

“The risk the economic and financial crisis is exposing is a steady rise in support for new and radical political parties in the periphery,” Alexopoulos and Hill wrote. “Preserving membership of the euro will increasingly be about preserving the value of wealth, rather than a political project.”

 

“And in the long term, that does not look particularly sustainable.”

 

Photo by Associated Press/Petros Giannakouris