The so-called troika — the European Union (EU), European Central Bank and the International Monetary Fund (IMF) — have finally reached an agreement with the government of Cyprus to bolster the island nation's economy and to help it avoid bankruptcy. Cyprus is the fourth country in the eurozone to receive a formal rescue, following Greece, Portugal and Ireland. With a GDP that barely exceeds $21 billion, Cyprus is also the smallest country to get a bailout.
In theory, lending aid to such a small economy shouldn't have made waves at a time when the monetary union is dealing with the much more expensive challenges facing its larger members. But in practice, Cyprus has become a bellwether.
On March 17, the troika and the Cyprus government reached an agreement at a time when the country needed some 17 billion euros to restructure its damaged financial system. The EU was only prepared to deliver 10 billion euros. All parties agreed that the rest of the amount would be obtained by imposing a tax of 6.75% on all bank deposits in the country below 100,000 euros, and a tax of 9.9% on those above that threshold.
Federico Steinberg, a professor of economic analysis at the Autonomous University of Madrid and chief researcher in international economics at the Real Instituto Elcano, notes in a brief commentary published by that institution that the troika did not want to give an external loan to Cyprus of 17 billion euros because the three bodies believed that the handout would be too big for the country to repay — setting the stage for the possible future suspension of payments or a write-off of the debt.
"That forced [Cyprus] to look for some formula for a 'bail in' [a participation of the banks' creditors in the rescue] in order to lower the bill," Steinberg noted, adding that "Cyprus has a financial system [that] is eight times the size of its GDP. Most of that consists of deposits, much of which belong to Russian companies that use the country as an offshore financial center for money laundering. So the only way to reduce the volume of the rescue was to impose losses on the depositors."
The decision was surprising for several reasons. For one thing, it was the first time that a rescue imposed a cost on the savers in a particular country. In theory, eurozone deposits are guaranteed for up to 100,000 euros.
Cyprus' parliament rejected the "bail in" proposal, and sharply criticized the fact that savers with smaller holdings would lose their money. European stock markets reacted to the decision by registering losses, dragged down by share prices of the banks, which suffered the worst damage. The risk premiums of some countries, such as Spain and Italy, increased in response to the news. In fact, during the Cyprus crisis, Spain's country risk rose from 346 basis points to 377, while Italy's rose from 314 to 347.
Under growing pressure, the troika and Cypriot politicians began to negotiate a way to change the conditions of the bailout proposal. The goal was for the country to obtain the extra money it needed beyond the 10 billion euros the EU was willing to offer without taking any funds away from depositors to accounts worth less than 100,000 euros.
On March 25, a definitive agreement was reached, guaranteeing protection for deposits of up to 100,000 euros, while imposing "write-offs" of about 40% for those that exceed that quantity. According to recent reports, the write-offs could be as much as 60%, since 22.5% of the deposited savings will be frozen for 90 days. In addition, the government must liquidate Laiki Bank and undertake a deep restructuring of the Bank of Cyprus, the principal institution on the island.
"The rescue of the Cypriot financial system is, in reality, a plan for its liquidation," according to Joaquin Arriola, a professor of applied economics at the University of the Basque Country. "I cannot understand some proposals, such as writing off 40% of the [value of] deposits of more than 100,000 euros — or the first of the [troika's] proposals, which [in effect] signified the death of the agreement made a couple of years ago to raise and unify the guaranteed deposits of the entire eurozone to [the level of] 100,000 euros."
Dutch politician and Eurogroup president Jeroen Dijsselbloem unleashed additional controversy when he assured the media that the agreement that was reached for rescuing Cyprus would be an example to follow for resolving future banking problems within the eurozone. In an interview with Reuters and the Financial Times, he said that if a bank gets into trouble, the institution will be asked to recapitalize itself. If it cannot do that, "then we will talk with the shareholders and the bondholders, and we will ask them to contribute to recapitalizing the bank, and if necessary also talk to the depositors whose deposits are not guaranteed [i.e. those with holdings that total more than 100,000 euros.]" Various officials within the European Union have responded with declarations that the case of Cyprus is unique.
Seeds of Doubt
Either way, many experts suggest that the case of Cyprus could spur significant change within Europe, establishing a turning point that will decisively influence the course of action in the event of future bailouts. "In the case of Cyprus, Germany has imposed a very different solution from the one imposed in the other three rescued countries," notes Wharton management professor Mauro Guillen, who is also director of the school's Lauder Institute. "This is a turning point because now, not even the small depositors seem to be secure."
He adds that the intrinsic damage of the rescue of Cyprus is that it can set a precedent. "The people of other countries whose banks have problems, such as Italy and Spain, may think that this can [also] happen to them; that their deposits are not safe. The true risk is that citizens can extrapolate from what has happened in Cyprus and think that their money is not safe in banks."
Indeed, Cypriots rushed to withdraw their savings from the nation's banks in the midst of the crisis. In order to avoid a massive flight of capital, the country's central bank had to shut down financial institutions and restrict the amount of economic transactions. For example, account holders were limited to a withdrawal of only 300 euros daily from ATMs on the island.
According to Guillen, the uncertainty that followed the events in Cyprus "puts pressure on the other banks, although this does not mean that people are going to go to financial institutions to take out their money." He adds that "things are not at all rational whenever there is a panic about banks, but if such a thing happens, it is logical for people to want to withdraw their money." Guillen points out that "banks have only about 4% to 5% of their money in cash, because the rest is in investments." As a result, "It is relatively easy to bring down the entire financial system."
Guillen says that the events in Cyprus have created a warning signal for politicians. "It is a sign that the method used in Cyprus is not the right way to do things. It is not necessary to punish small savers."
The New Rules for Rescues
Joaquin Arriola interprets the rescue of Cyprus as a step toward changing the methods of dealing with financial crises in Europe. "The leaders of the EU have long been saying that they have to modify the procedures for managing the crisis of financial institutions, so that the rescue of private institutions should not have repercussions on the overall community of contributors, who have already contributed 4.5 million euros."
But Arriola notes that this can be avoided only if the EU is prepared to limit the usage of public funds for helping institutions with liquidity problems, and to accept the bankruptcy of insolvent institutions.
Guillen also sees possible changes ahead in the criteria for how bailouts are structured, specifically in the case of Germany, where he says there is a diversity of opinion about the topic. "The small German savers do not want inflation, nor do they want to collaborate in the rescues," he notes. "But in Germany, there are also large companies for whom the European market is very important. These companies want stable countries to exist in the region — countries that can grow. This would not only benefit the companies themselves, but it would also benefit their workers. In addition, there are small family-owned enterprises that do not invest much money that are also opposed to the rescues. However, at the same time, there are many small firms and individual citizens who view the rescues as necessary for the future of the country."
In his view, it is not realistic for Germany to "say that it is already sufficient, and that it is not going to put more money into rescues, and that the rest of the countries should get by as well as they can." About 40% of German exports go into the region, notes Guillen, adding that the latest crises in Germany have been precipitated by the instability that existed in the other countries that surround it. "At times like this, I do not believe that Germany has the option to choose," he adds.
For Federico Steinberg, the case of Cyprus presents "two important lessons" about how to make progress in resolving the euro crisis. The first is that each rescue is different, and the balance of power between the competing interests involved makes it impossible to generalize. "Thus, in Greece there was a restructuring of the debt; in Cyprus, there has been an extremely difficult 'bail in.' In the case of Ireland, which was not permitted to have any rescue in 2011, the ECB tolerated a covert monetization agreement; and in the case of the Spanish banking rescue, the 'bail in' has been very reduced in scale, affecting only the senior and subordinate debt — two complicated financial products that were marketed by Spanish banks. The buyers of these products of bankrupt institutions are going to lose part of their investment."
The second lesson is that "the creditor nations of the eurozone have made it clear that they will not take charge of the so-called legacy assets of the financial systems that they rescue; that is to say, until the point where the [EU's proposed] banking union is enacted and there is a sole supervisor that controls the excesses of the [various] national financial systems [of EU member states], each country will have to take charge of its financial irresponsibility. And if doing that makes the public debt grow too much, they will look for formulas for a 'bail in.'"
According to Arriola, the uncertainty among savers and investors generated by the rescue of Cyprus could lead to capital flight in Europe. "Movements of capital tied to the risk of rescues are going to mean greater movements from some countries (in the south of Europe) to others (in the north) within the eurozone itself."
Arriola adds that the rescue of Cyprus represents "without doubt" a more belligerent policy against countries considered to be tax havens. "Cyprus is being treated like a [tax haven], as is Switzerland, which is outside the EU. On the other hand, other locations maintain their character as tax havens both within the eurozone — Luxembourg — as well as outside of it — London, Gibraltar. For the moment, the EU is taking no measures to do away with [such havens]," he says.