The Cyprus precedent

March 17, 2013
stuck my neck out in January, saying that Cyprus was "certain" to default.

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I stuck my neck out in January, saying that Cyprus was “certain” to default. After all, the Europeans weren’t willing to come up with the €17 billion needed to bail the country out, and EU economics commissioner Olli Rehn told the WSJ’s Stephen Fidler that Cyprus would have to restructure its debt. But now the bailout has arrived, and — in something of a shocker — there’s no default. Instead, €5.8 billion of the bailout is going to come directly from depositors in Cyprus’s banks, in the form of what the EU is calling an “upfront one-off stability levy”.

Don’t for a minute believe that this decision is part of some deeply-considered long-term strategy which was worked out in constructive consultations between the EU, the IMF, and the new Cypriot government. Instead, it’s a last-resort desperation move, born of an unholy combination of procrastination, blackmail, and sleep-deprived gamesmanship.

The details aren’t entirely clear yet: we’re told that deposits of more than €100,000 are going to have to pay a tax of 9.9%, for instance, but it’s not obvious whether that applies to all of the large deposit or just to the amount over €100,000. And there’s still a real chance that the Cypriot parliament could scupper the whole deal. But for the time being, everybody’s going on the assumption that the deal will go through, that Cyprus will get its €10 billion bailout from the EU, and that everybody with a Cypriot bank account in Cyprus (a group which includes members of the UK military) will see their accounts taxed by at least 6.75%.

In January, I said this wouldn’t happen:

The last thing that Cyprus or any other country needs is a bank run, which will leave the national balance sheet in the classic pinch where “on the left, nothing’s right, and on the right, nothing’s left”. What’s more, in many ways the precedent of forcing depositors to take a haircut would be even more damaging than the precedent of imposing a haircut on Greek bondholders: at that point there would be really no reason at all to have deposits in any Mediterranean country.

It might seem a little bit like shutting the stable door after the horse has bolted, but the lines in front of broken ATMs certainly suggest that there will indeed be a substantial bank run out of Cypriot banks when they reopen on Tuesday morning. (Cyprus’s loss, here, is likely to be Latvia’s gain.) Cyprus has been relying up until now on its status as an offshore financial center, especially for Russians. That has bloated its banks with deposits, and if the deposit bubble bursts, the government has no money at all to bail out the banks. Cyprus’s president, Nicos Anastasiades, said today that he was forced to choose this path because the only alternative was the collapse of Cyprus’s two major banks, with “catastrophic” consequences. What he didn’t say is that those banks aren’t remotely safe yet — not with the prospect of a massive bank run hanging over their heads.

And of course it’s not only Cyprus where a bank run is a very real fear. If bank deposits can be seized in Cyprus, they can be seized in other EU countries as well. Ed Conway has a fantastic post explaining exactly why this is a horrible idea:

Given that this policy was not merely rubber-stamped but engineered by Eurozone finance ministers and the IMF (indeed, the IMF wanted an even deeper cut of deposits), it sends a disquieting message to anyone with deposits in a euro area bank. Although the ministers were quick to insist that this is a one-off and is “exceptional”, anyone even vaguely acquainted with the initial Greek bail-outs will remember precisely how long such exceptions last.

“The best the rest of the world can hope for,” says Neil Irwin, “is that Cyprus’s case is sufficiently unique that it won’t spark panic in Athens and Madrid (or in Lisbon, Dublin and Rome).” But his post is headlined “Why today’s Cyprus bailout could be the start of the next financial crisis”, which gives a reasonably good idea of how optimistic he is that any bank run in Cyprus will be contained.

And Europe won’t be home dry even if depositors in Portugal do decide to keep their money in their home country on Monday morning. That might make this bailout look like a brilliant wheeze. But the consequences of this choice are permanent: countries like Ireland and Portugal might not be at risk of a deposit tax right now, but they’re still getting bailed out on a continuous basis, and the more fraught the bailout negotiations become, the more likely it is that the EU will insist on bailing in depositors. It’s an option on the table, now, and as a result a deposit run is surely more likely to happen whenever a Eurozone country finds itself in need of a bailout. Which, of course, is always the worst possible time for a bank run.

From a drily technocratic perspective, this move can be seen as simply being part of a standard Euro-austerity program: the EU wants tax hikes and spending cuts, and this is a kind of tax: “a one-off wealth tax”, as Matt Yglesias puts it. Other taxes would raise less money, or if they didn’t they would be more harmful to the Cypriot population, since much of this one is going to be paid by Russians. Cypriots are sadly going to have to pay somehow, and although this is an unpleasant way of forcing them to do that, it’s also extremely effective and almost impossible to replicate by any other means.

But there’s something sacred about bank deposits, and especially about insured bank deposits. The one part of this scheme that no one is defending is the 6.75% tax on deposits less than €100,000 — the level to which Cyprus guarantees all deposits. As Nick Malkoutzis puts it,

Anastasiades also has to explain to Cypriots why small-time depositors have to pay a similar levy to the one some eurozone countries supposedly demanded so alleged Russian oligarchs would be forced to pay for bailing out the island’s banking system. Furthermore, he has to inform them why the Cypriot government’s pledge to guarantee deposits up to 100,000 euros – supposedly even in the most extreme circumstances – is not even worth the paper it was written on.

What we’re seeing here is the Cypriot government being forced to break one of its most important promises — the promise that if you put your money in the bank, and your deposits total less than €100,000, then they will be safe. What’s more, there’s no good reason for insured deposits to be hit in this manner: the same amount of money could be raised just by taxing the uninsured deposits at a slightly higher rate. The insured depositors are being hit, it seems, just so that the uninsured depositors can be taxed at single-digit rather than at a double-digit rate.

Meanwhile, people who deserve to lose money here, won’t. If you lent money to Cyprus’s banks by buying their debt rather than by depositing money, you will suffer no losses at all. And if you lent money to the insolvent Cypriot government, then you too will be paid off at 100 cents on the euro.

This is more by accident than by design. As Joseph Cotterill explains, Europe dragged its feet on Cyprus for so long that it effectively missed the deadline for doing a bond restructuring. It takes time to put that kind of a deal together, and there simply isn’t enough time between now and Cyprus’s next big coupon payment to do that. As a result, the EU found itself with a massively reduced menu of options: either fund the bailout itself, in full — an option which the Germans were adamant would never happen — or force a haircut on Cyprus’s depositors. Given the balance of power in the Eurozone, it comes as no surprise that in this battle, Germany won and Cyprus lost.

They won dirty, too: by forcing a tough all-night negotiating session in which Anastasiades was given what you might call an offer he couldn’t refuse. Either confiscate deposits wholesale, or see those deposits rendered even more worthless when the ECB cuts off its funding to Cypriot banks, a decision which would — through devaluation and insolvency — lead to depositors losing as much as 60% of their money.

The big winner here is the ECB, which has extended a lot of credit to dubiously-solvent Cypriot banks and which is taking no losses at all. And although they might wake up bruised, the big Russian depositors are probably winners too, given that they risked losing everything and will end up losing just 10%. Finally, of course, there are all the hedge funds who have been betting that the Cypriot government won’t default: they’re all popping Champagne right now.

The big loser are working-class Cypriots, whose elected government has proved powerless in the face of decisions driven by Germany, and who are now edging towards fury. The Eurozone has always had a democratic deficit: monetary union was imposed by the elite on unthankful and unwilling citizens. Now the citizens are revolting: just look at Beppe Grillo. Across the continent, they’ve lost their democratic right to determine their own fate at the ballot box, and instead they’re being instructed what to do by Germans. Now, in Cyprus, they’re simply and directly losing their money.

Someone with €8,000 of life savings in the bank can ill afford to lose an arbitrary €540, but that’s exactly what is going to happen. The Cypriot parliament is probably not going to revolt this weekend, but any politician who votes for this bill is going to have a very, very hard time getting re-elected. This decision is important not only because of the precedent it sets with regard to bank depositors, but also because of the way in which it points up just how powerless all the Mediterranean countries (plus Ireland) have become. More than ever before, it’s Germany’s Europe. That’s bad for Cyprus — and it’s not even particularly good for Germany.


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