Posted Friday, March 22, 2013, at 9:29 AM
Employees of Cyprus Laiki Bank gather outside the parliament in Nicosia during a protest on March 22, 2013.
Photo by PATRICK BAZ/AFP/Getty Images
The Cypriot government today floated another plan and the European Union rejected it. Banks have now been closed all week and people are getting antsy. The EU says Cyprus has until the end of the weekend to figure out what's happening or else it may be in effect booted from the eurozone. What's going on?
How Much Money Does Cyprus Need? Well there are two answers to this. One is that it needs about €17 billion. Of that, the European Union says it's willing to offer €10 billion if the Cypriot government can come up with another €7 billion. There's a plan in place for Cyprus to raise €1.2 billion that's uncontroversial. So the issue is that Cyprus needs to find €5.8 billion in order to get the €10 billion.
Why Does Cyprus Need €17 Billion? Cypriot banks swollen with deposits from outside the island needed to find profitable investments for the money. They chose, unfortunately, to believe that their comparative advantage was in investing in Greece. So when Greece collapsed those investments turned bad, rendering Cyprus' two main banks insolvent.
What Happened With That First Plan? The initial plan was to raise €5.8 billion by haircutting every deposit in a Cypriot bank. There would have been a smaller haircut (6.75 percent) on deposits up to €100,000 and a larger 9.9 percent haircut on deposits above €100,000.
What's The Significance of the €100,000 Threshold? Two issues. One is that deposits of up to €100,000 are formally covered by Cyprus' deposit insurance scheme—their version of the FDIC—so tapping those deposits is breaking a major taboo. The other is that while most of the value of the deposits in the Cypriot banking system is held by foreigners (largely Russians), the vast majority of ordinary Cypriots' savings are in Cypriot banks. The haircut on big deposits is largely a penalty on foreigners, the haircut on smaller deposits is a penalty on Cypriots.
Why Doesn't The Government Save The Small Depositors And Take All The Money From The Rich Russians? Nobody really knows! For a while Cypriot officials tried to blame this aspect of the plan on the Germans, but the Germans deny that. Then officially they said the reason was that they don't want to just hammer the big deposits because they want to preserve Cyprus' offshore banking industry. That doesn't stand up to much scrutiny though. Even a 9.9 percent haircut is big enough to end the party. One theory is that Cypriot officials are just protecting the interests of rich Cypriots. Another is that they're afraid of the Russian government or maybe even the Russian mob. Who knows?
What Have They Been Doing All Week? Basically trying desperately to come up with an alternative to taxing bank deposits. A more generous deal from the European Union, a bailout from Russia, anything. But Germany's position on this is that Cyprus needs actual cash money—€5.8 billion of it—and not some new kind of loan. Their view is that Cyprus needs to actually reduce its net indebtedness by turning some aspect of national wealth into money, not just roll over existing debts. The gas-backed loans clearly run afoul of that principle. Tapping the pension funds of state-owned firms sort of does as well, since the pensioners don't vanish just because you've stolen their pensions.
What Happens If Cyprus Doesn't Come Up With Something? Officially, absent the €5.8 billion they won't get the €10 billion. And officially, without that money to recapitalize the major banks the European Central Bank will halt what's called "Emergency Liquidity Assistance" to the country's main banks. At that point, Cyprus will in effect be off the euro. Its banks, at a minimum, will be cut off from the eurosystem. How the country actually deals with that situation is anyone's guess.
Will Cyprus Leaving The Euro Be A Gigantic Catastrophe? Maybe. Or maybe not.
What's The Optimistic Take? Cyprus is actually a pretty good candidate for "the full Argentina" of default and devaluation. Its status as an offshore banking center is done one way or another, which leaves tourism as the main tradeable industry. Tourism is the kind of industry that can be greatly boosted by currency devaluation, since suddenly the price of everything a foreigner might come to do in Cyprus is reduced. Meanwhile, for the rest of Europe it is clear that Cyprus did in fact have a path to stay in the eurozone—tax those large offshore deposits. It left not because the eurozone is crumbling, but because one of its newest (just since 2008) and smallest (substantially smaller population than the Bronx) members voluntarily left in a misguided and ultimately futile effort to secure the interests of Russian tax dodgers and money launderers.
What's The Pessimistic Take? Prosperous Greek people may look at what happened in Cyprus, look at the strong standing of the leftist Syriza party in the polls, and decide to keep all their liquid savings in shoeboxes full of cash. Bank runs, in other words. Then essentially the European Union will be faced with a scaled-up version of the Cyprus problem. All the numbers get bigger. And there are no Russians to soak. At best, Germany will find that the fiscal cost of averting a post-Cyprus disaster is much bigger than the fiscal cost of just giving Cyprus the damn €5.8 billion. At worst, the scale of the Greek crisis will prompt dawdling and spur bank runs in Portugal and Spain and even Italy—which remains politically paralyzed after an election that produced no governing majority—spiraling the problem way out of control.
So What's Really Going To Happen? My gut tells me that there's a face-saving compromise to be reached in which the Germans get slightly more generous and the Cypriots get real about the inevitable doom of their banking industry. Cyprus raises 90 percent of what the Germans want via taxing the large deposits, the rest is fudged away, and everyone lives to fight another day.
Has This All Been A Huge Unforced Error? Perhaps. This was an eminently kickable can. But something tells me that we were close to a great deal here. Making creditors pay rather than fully bailing them out was a good idea. Had the initial plan simply called for a 15 percent tax on uninsured deposits worth over €100,000, I think we might have looked back on this episode as an important step in taming out-of-control finance. Instead, it got mixed up with a brutally unfair plan to screw small insured depositors, and we've been adrift for a week.