The Cyprus crisis is likely to generate a number of political and economic problems for the country in the short term. Charles Goodhart assesses the impact on Cyprus’s economy and the fallout from the bank levy imposed on large depositors at Cypriot banks. He argues that although the potential for contagion to spread to other Eurozone countries has not yet been realised, the consequences for the European banking system could be severe.
The Participants
The Cypriot banks held a large amount of Greek bonds, as well as loans to Greek borrowers, and they were driven into insolvency by the prior Greek disaster, (especially p.s.i., private sector involvement, e.g. for the Cypriot banks, in the Greek bail-out). This had been known for some time, but Cyprus is so small, and the sums involved sufficiently minor, that delay was feasible; and it allowed the participants to think in terms of principle rather than be pushed by issues of practicality.
The main issue of principle that drove the Troika – the European Commission, European Central Bank (ECB), and International Monetary Fund (IMF) – was the political hostility of voters in Germany and other Northern Eurozone countries to provide support for large, especially Russian, depositors in Cypriot banks, which provided tax-haven, and purportedly money-laundering, facilities for Ukrainian and Russian borrowers. The intention of the Troika was to provide funding for the Cypriot government, but to force the banks to recapitalise themselves by bailing-in their own large creditors. If that should destroy the tax-haven business plan of the Cypriot banks, so much the better.
The player in the game whose actions are, perhaps, most difficult to comprehend and to reconstruct is Russia. It was clear that Russian interests in Cyprus were one of the main targets, but apart from a few early squawks about the Commission’s failure to consult and the exercise being improperly done, the Russian authorities have said, or done, almost nothing, despite the pleas of Michael Sarris, the Cypriot Minister of Finance. The amounts are small enough for the Russians to have bought out the banks and rescued the Cypriot government. But, whether the European authorities (and the US) would have allowed Cyprus to remain in the Eurozone (and EU) had it become a Russian vassal state is uncertain. Also the role of Cyprus as a money-laundering tax-haven will have reduced tax revenues in Russia, so the attitude of the Russian authorities to Cyprus was always likely to be ambiguous. And possibly they feel that the bail-out may yet fail, so they can pick up the pieces cheaper later. Anyhow, whatever the reason, the Russians have remained largely passive, at least for the time-being.
The Cypriot negotiators originally hoped to maintain their ‘business model’ by keeping the hair-cut on large uninsured depositors to below 10 per cent. With there being only a handful of bank bond-holders, this implied a sizeable (6.75 per cent) levy on smaller insured depositors. Although, probably out of exhaustion, the Troika initially accepted this, it soon got comprehensively shot down, both within and without Cyprus itself. The subsequent terms became much tougher on the uninsured depositors and on the Cypriot banks themselves, with Laiki driven into insolvency and closed, and the Bank of Cyprus Greek branches sold and its Chairman pushed out.
Following some twelve days of bank closure, Cyprus was subject, inevitably, to strict capital controls, its banking system in tatters and the economy facing a steep recession, with commentators fearing a decline in GDP of 20-25 per cent. The expropriation of deposits over €100,000 of as much as 40 per cent in the Bank of Cyprus, and probably much more in Laiki, will not just hit wealthy, and perhaps unsavoury, Russians, but also many decent upright Cypriot institutions, schools, hospitals, universities, and private sector companies. The pain, suffering and unemployment will be intense.
Did the Cypriots have an alternative, given how horrible the current outcome is? Could they have simultaneously devalued, left the euro and defaulted on their external debts? They could then have recapitalised their banks using Cypriot pound bonds, while the devaluation would have made tourism more attractive. The main problem, I would guess, would have been their insufficiency in fuel (for the next few years until their shale gas reserves become available). Cyprus would not have been able to borrow abroad, and they would therefore have been forced to maintain a current account in balance, or surplus, from day one. Moreover, they would probably have been forcibly ejected from the EU, though it is arguable quite how detrimental this might be. We may never know how close Cyprus got to walking out.
Implications
Cyprus is being turned into a basket case, whether intentionally or not. This has numerous consequences. First, even after a massive bail-in and restructuring, much of the value of Bank of Cyprus assets will disappear (both Cypriot and Russian). Will the ECB be prepared to go on pumping money into the Bank of Cyprus as its depositors try to flee, its assets become non-performing, and its collateral disintegrates? But can it close down the only remaining nation-wide bank there? Meanwhile the pain is likely to make the current President and his party highly unpopular. Even if Parliament cannot vote on the rescue deal itself, a vote of ‘no confidence’ is always possible. And then what?
Outside Cyprus, the lesson is that (large) deposits are at risk, and that the Troika will, perhaps if forced by Northern public opinion, impose severe penalties on any Eurozone country whose banks are both fragile, and too large for the sovereign to save. Will this lead to contagion? Perhaps not. The sang froid of financial markets during the Cypriot imbroglio has been remarkable. But there is a risk. Should that risk eventuate, the potential destruction could be massive.
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Note: This article gives the views of the author, and not the position of EUROPP – European Politics and Policy, nor of the London School of Economics.
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Charles Goodhart – LSE Financial Markets Group
Charles Albert Eric Goodhart, CBE, FBA is a Senior Economic Consultant for Morgan Stanley. He was a member of the Bank of England’s Monetary Policy Committee from June 1997-May 2000 and a professor at the London School of Economics (1985–2002, Emeritus Professor since 2002).
The lesson Charles Goodhart draws from Cyprus is that the troika will clamp down on TBTF banks. Well, no sign of that yet. Plus there is not even any sign that the TBTF problem has been solved, as pointed out by both Mervyn King and Bernanke. And that’s notwithstanding the millions of person hours that have gone into Dodd-Frank, Vickers and Basel III. As King pointed out, Basel III will not stop the next crisis.
The word “shambles” springs to mind.
I draw a different lesson from Cyprus, as follows. One of the fundamental points made by advocates of full reserve banking is that it is ridiculous to offer depositors 100% safety while letting banks lend on depositors’ money in a less than 100% safe manner (particularly to the Greek government). That strategy inevitably means the taxpayer takes the ultimate risk.
Under full reserve, depositors are made to choose between, first having their money lodged in a genuinely 100% safe manner: e.g. having the money lodged at the central bank where it cannot possibly be lost. Second, depositors can choose to let their bank lend on or invest their money. But in that case depositors foot the bill if it all goes wrong.
That system would have resulted in Cyrpus being a storm in a tea cup. Depositors who had chosen 100% safety would not have lost anything. While those who had chosen to have their money put at risk would have taken a hair cut: but that would have been nothing more than they signed up for when first depositing their money.
The whole TBTF question becomes irrelevant under full reserve, because under full reserve, banks as such cannot fail.
The lesson from Cyprus that Charles Goodhart draws has nothing to do with TBTF banks but with the question whether large bank depositors should be spared when banks go bust. This is a risk when financial markets are so nervous, as Charles Goodhart indicates at the end of his blog.
But for once, I think the EU’s crisis management got it right and it was a risk worth taking. The EU asked for a co-payment from Cyprus because of the manifest free-riding on other countries’ tax base that Cypriot governments have engaged in over the years.
Co-payments are a standard way of reining in Moral Hazard in insurance. Deposit guarantee schemes all over the world stipulate such co-payments and the EU’s own Directive on this guarantees only deposits up to €100,000. The Moral Hazard is that savers take their money to reckless banks that promise them conditions and interest rates that no prudent bank can offer — and thereby threaten to drive prudent banks out of business.
The EU left it to the Cypriot government how to levy this co-payment, as it should be in a union of democracies. However, the Cypriot government proposed a potentially unlawful solution, so as to protect it cronies, large deposit holders, from losses that would exceed the usual tax rate of 10%. To repeat: it was the Cypriot government that wanted to reid small bank deposits, not the EU. The EU protected small Cypriot savers from their own government’s sucking up to rich foreigners at the expense of other countries, including Russia.
The EU is a union built on the principles of reciprocity and solidarity. Cyprus has exercised precious little of either ever since it entered the EU. Hence, it could not expect solidarity from other member states it has exploited over the years (the EU still contributes 2/3 of the costs for this programme, and that’s how it should be because one cannot hold an entire people hostage for the follies of its elites). This was good politics and good economics in my view.
The real lesson that should be learnt from Cyprus is that the reference to huge sums of Russian money was a myth put out by the politicians of Germany, Finland, Holland and Austria to justify the theft of billions of euros from a majority of perfectly legal businesses. For example, the owner of the filling station where I fill my car, lost six hundred thousand euros during the bail- in. Jumbo stores, a Greek owned company which sells household goods and toys, had nineteen million euros confiscated. This highly reputable Greek company is situated a few kilometres down the road from the petrol station in Larnaca, Cyprus, where I live. This act of political expediency is likely to be repeated throughout Europe in the future. More lies will be told by ruthless politicians in order to protect capital in German banks before the next axe falls.