Lessons of the Cyprus bailout

In: Uncategorized

25 Mar 2013

This week’s Perspective column looks at the Cyprus deal. Although the article was submitted last Monday, with a lot happening in the interim, in some respects (such as the principle of taxing bank depositors) things have moved full circle since then. Depositors with less than €100,000 in savings will no longer be subject to the levy but the whole Cypriot economy is likely to suffer as a result of the deal.

It is not hard to see why the €10 billion (£8.5 billion) bailout of the small island of Cyprus has become almost the ultimate middle class nightmare. The spectre of the authorities in effect taking money away from small savers has shaken relatively affluent individuals across Europe.

It is not quite as shocking as secret police arresting innocent people in dawn raids. But it is a reminder that governments can wield enormous power even against individuals who are not accused of any wrongdoing.

It also happened somewhere most British people see as benign. For many Cyprus represents sunny beaches as well as clubbing in Ayia Napa. The island also includes the British military bases of Akotiri and Dhekelia, a legacy of colonial rule, but the last armed conflict was back in 1974 when Turkey invaded. Although the island is still divided between the Greek Republic of Cyprus in the south and a Turkish enclave in the north the border is peaceful.

Yet despite the shock the tax on depositors has engendered is not the most significant aspect of recent developments in Cyprus. More important is the implication that the eurozone crisis is still far from over. To understand why this is the case it is necessary to look more closely at recent developments.

Cyprus mainly got into difficulties as a result of a knock-on effect of its close ties to the troubled Greek economy. Although Greece is relatively small its economy is still more than 10 times the size of Cyprus. Two of the largest Cypriot banks are among the largest holders of Greek bonds and have an extensive presence in the mainland.

As a financial centre the island is also vulnerable to falling liquidity. Its economy is largely based on tourism, financial services and real estate. It has little of an industrial base.

Back in July the government requested a bailout from the “Troika” – the European Commission, European Central Bank and International Monetary Fund – although it took many months to negotiate. Evidently the tax on depositors was imposed externally although the decision to include small savers in the squeeze was made by the Cypriot government.

Suppliers of funding for the bailout, including Germany, were keen that a large part of the island’s funding needs were covered domestically. As a result external bondholders could be exampled from having to take a haircut.

However, it was the Cypriot government that decided to tax small savers as part of the deal. Evidently it did so to limit the impact on larger depositors. To achieve this goal it had to find legal loopholes to ensure that deposit insurance was not triggered for those with small savings. Savers will be recompensed with shares in their depositor banks but these are of dubious value.

Several features of bailout package are already noteworthy from this sketch. First, it is clear that the northern European states have decided to squeeze troubled countries particularly hard in exchange for bailout money.

The tax on small depositors broke an unwritten rule that they should be exempted from the impact of financial crisis. Since the Great Depression of the 1930s it has become widely accepted that savers should be protected from such trouble. Indeed back in 2008, at the start of the global financial crisis, the leaders of both Germany’s main political parties emphasised that the deposits of their own small savers were secure.

Deposit insurance was not made for altruistic reasons. The idea is to protect banks from dangerous runs when savers lose confidence in the institutions in which they deposit their money.

This brings us to a second implication of the deal. Despite attempts by the authorities to downplay it the Cyprus is likely to increase the risk of bank runs elsewhere in Europe. Savers will be more prone to withdraw their money in panic if they think it is threatened.

No doubt all that talk of Russian “money laundering” through depositing savings in Cyprus was designed to discredit any objections to the deal. There was no action against specific Russians accused of any illegal activity. Instead it appeared more like a cynical ploy to imply that many of the deposits that were taxed were in some way linked to the Russian mafia.

However, the main lesson from Cyprus fall-out is that the eurozone crisis is far from over. It is true that the eurozone’s leaders have shown a remarkable determination to keep the organisation’s institutions intact but that is not the same as resolving its underlying problems.

The fact that events in the island nation with only 0.2% of the region’s output can spark such panic across Europe is itself remarkable. Incorporating such desperate measures as bypassing deposit insurance is a sign of weakness rather than strength.

Among the many other problems facing the eurozone are the unresolved government negotiations in Italy. Clearly the technocratic solutions favoured by the previous government proved deeply unpopular even though no real alternative is being offered.

At it most fundamental the huge gaps in productivity levels between different eurozone member nations remains a source of instability. Cyprus is unlikely to be the last episode of this ongoing crisis.