Introducing the Latest Euro Zone Contagion: Cyprus

March 18, 2013

Zachary Fillingham

EU symbol on map

Geopoliticalmonitor.com

The latest developments coming out of Cyprus might not seem overly dramatic: swapping the abstract, shared liability of taxpayer money for a more direct one in bank savings accounts. But in this small policy pivot lies the seed for a new and potentially ruinous fear that could spread through the peripheral European markets.

There is a simple logic underpinning the Cyprus bailout: Cypriot banks engaged in risky lending in the lead-up to 2008 and they should be punished for it. The only problem is that they can’t be punished too rigorously or they risk toppling over, taking the economy of Cyprus and, to a certain extent, Europe along with them.

Once more we come up against the increasingly familiar refrain that Cypriot banks are ‘too big to fail.’

In an effort to resolve this contradiction, the Troika has agreed to impose a direct levy on Cypriot bank customers in exchange for a $13 billion bailout. The levy amounts to a one-time fee of 6.75% on deposits under the 100,000 euros and 9.9% on deposits over 100,000. All affected bank depositors will be compensated with shares of their bank, and some banks are offering rewards for customers who keep their deposits in place over the next two years.

Although one might see the logic behind this latest decision by the EU and the IMF- after all, if the banks had been allowed to collapse, depositors would be losing a lot more than 9.9%- it still represents a new source of uncertainty in global markets, and Asian markets have already reacted to the news by showing red after weeks of gains. After the opening bell on Monday, it is likely that European and North American markets will follow suit.

Global markets aren’t reacting negatively out of concern for the impact on the relatively small Cypriot economy. Rather, they are dropping over concerns that the Cypriot bailout will serve as a precedent for future bailouts. Up until now, bank customers have not been made to be directly liable for irresponsible bank lending.  In the future, that might not be the case.

There is a danger of a capital flight, not just from Cyprus, but from the peripheral European economies as well- those economies that investors believe to be in line for a future bailout. People have been rushing to bank machines all over Cyprus since the terms of the bailout were made public, and many savers are desperate to get their money out before the levy goes through. A bank holiday was announced for Monday to stem this kind of panic, and it could be extended through Tuesday if parliament still hasn’t agreed on the bailout deal.

There is however another school of thought that believes the unique character of the Cypriot banking sector precludes the possibility of the bailout being used as a future template. These analysts point to the size of Cypriot banking vis-à-vis the euro zone and the high level of overseas deposits as two factors that set Cyprus apart.

Some are questioning why the Troika waited until now to target savers, and the answer likely has to do with the simple fact that Cyprus is an easy target, as it only represents about 0.2 percent of euro zone economic output. It is also the preferred destination for Russian money, as the 10,000-strong Russian community in Cyprus is said to account for as much as 35 billion euros in deposits.

Whether or not the Cyprus bailout even passes is another question. President Nicos Anastasiades seems to have been caught off guard by the vigorous response from the Cypriot population. There are three parties in the 56-member parliament, and the vote will come down to one or two individual decisions. In order to soften the blow and make the deal more presentable to the population, the Cypriot ministry of finance is working on an amendment to the deal that would offer more protection to small-scale savers. Unconfirmed reports suggest that they’re pushing for a reduction to a 3% levy for the under 100,000 bracket, and an increase to 12.5 percent for the savers with over 100,000 in their account.

Interestingly, there were a few other strings attached to the Cyprus bailout that have been dwarfed in the press by the deposit levy issue. These include the demand that Cyprus boost its corporate tax rate, downsize its banking industry, and perhaps even privatize its electricity and telecommunications industries.

Zachary Fillingham is a contributor to Geopoliticalmonitor.com 

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