Sunday, March 24, 2013

The Cypriot Mess

The recent Cypriot crisis shows that the eurozone debt crisis is far from over. We have a situation which is to some extent similar to Iceland. The Cypriot parliament has rejected the bailout plan put forward by the ECB to protest against to the proposed levy on bank deposits.  If this were to happen, big depositors may lose up to 40% of their money which has caused anger from Russia. 
But Cyprus chose to tax small deposits to limit losses of Russian oligarchs. 

The crisis has a clear geopolitical dimension due to the large presence of Russians in Cyprus banks. As the country is heavily reliant on financial services, this could trigger a massive capital outflow, which would worsen the current account balance, already high due to an overevaluation of prices and costs. 

Cyprus'economy is small in economic terms, around 0,2 % of the eurozone GDP. But it has a large  financial sector whose development is driven by  offshore capital due to high rates on savings and opportunities for tax evasion.  Cypriot banks have invested in Greece and in the real estate sector which has caused a financial bubble like in Ireland or Spain. This means more financial losses for the Cypriot banks which are not able to pay off their debts, hence the levy on deposits.  The combination of these two additional elements - financial bubble and loss of competitiveness due to high costs - may leave Cyprus in a Greek type situation with high sovereign debt and may be pushed to leave the euro.   

What lessons can  we draw from this crisis? 

The first one is that the Cypriot mess has caused a crisis of confidence in the eurozone system. In the middle of the financial crisis, the EU established a system of deposit guarantee to €100.000 to prevent bank runs. Now this rule may be breached if Cyprus were to inflict a taxation to savings under that threshold. Under a properly functioning banking union, heavier losses would have been imposed on large deposits but small depositers would have been saved; in addition, banks would have been recapitalised by the eurozone. The ECB remains the ultimate guarantee of the survuival of the euro, and most probably will defend Cyprus as it did for Greece from getting out of the euro. 

Second, the protection of small depositors is an essential element of a modern banking system. Institutions are therefore a critical factor for maintaining financial stability. Especially in the globalization context, where weak countries are more vulnerable to external shocks, the demand for clear rules and norms has increased, in particular to avoid any further increase in inequality while social safety nets are needed.

Third, Cyprus may still have the illusion that it would keep its 'business model' but the crisis makes it clear that it has  rebuild its economy on a more sustainable basis. This means it has  to downsize much of its financial sector with stricter rules on foreign savings and diversify its economy on other sectors such as tourism and culture.

W.Munchau, the FT editor, believes that that there is no"moral or economic reason to protect foreignerswho have decided to park large sums in a Cypriot bank account for whatever reason".  This means, on the contrary, that moral and economic considerations exist for small domestic depositors. 


3 comments:

  1. Early morning of today , the eurogroup has approved a second bailout. The deal only affects deposits in the two largest banks - Laiki and the Bank of Cyprus - accounting for about 40 percent of total deposits in the country. The size of the financial sector will be downsized and the two banks bailed in but the condition is that the sovereign debt does not exceed 100% of GDP. the austerity machinery will come in with downgrading of Cypriot bonds, possible euro exit, payments from the ESM linked to spending and wage cuts. we have seen this in Greece and we know how it ended up.

    ReplyDelete
    Replies
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  2. The nation’s deficit is expanding and edging Cyprus towards a requirement for EU funded financial assistance. But I wonder if EU will help them until they recover from this economic crisis.

    us financial crisis

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