Cyprus bailout shows euro problems far from over

When Greece restructured its debt last year, forcing investors and bondholders to take a hit, many Cypriot banks, which held billions in Greek government bonds, also suffered huge losses. The Cypriot government took on debt, which it couldn’t afford, to bail out banks. Eventually, it went to the European Union (EU) to request a bailout, a familiar story.

The latest deal will look to downsize the biggest banks in Cyprus and restructure the banking sector. The centrepiece of the deal is to shut down zombie bank Cyprus Popular Bank (or Laiki), nationalised last year. The Bank of Cyprus will take over the viable assets of the failed bank along with 9 billion euros in central bank aid.

Small depositors will be spared from having to pay a levy, which had been part of the original plan that sparked protests two weeks ago. But uninsured depositors – those with more than 100,000 euros – will see their funds almost entirely wiped out. Uninsured depositors at Bank of Cyprus will see losses of up to 40 per cent. It is unclear how much this will cost bondholders and large depositors but one can safely assume it will be billions of euros. In return, Cyprus will get loans of about 10 billion euros.

The world, it would seem, can breathe a sigh of relief over yet another economic calamity avoided. But the deal to save the leaky Cypriot ship may end up setting the stage for even further turmoil in the EU.

What the deal has done is to stem the probability of an outright crisis. Cyprus is a tiny country of just 1.1 million people, with an 18-billion-euro economy, less than a tenth of Singapore’s. But if Cyprus had gone under, the consequences would have been dire. For one thing, the fear of financial contagion is very real. If the EU had allowed Cyprus banks to fail and the government to default on loans, there is no telling how the market would have reacted. Borrowing costs for other vulnerable indebted nations could rise, and this could trigger another flare-up of the debt issue, which has otherwise been stable for the past half a year.

The other big worry: a bank run. As it is, there were many reports of people queueing up outside ATMs to withdraw cash en masse. A bank run in small Cyprus could trigger panic among savers in Europe, the very thing leaders there have been trying to avoid.

The deal, it seems, has put paid to these fears, perhaps giving credence to analysts who believed the crisis could be contained.

But the biggest problem with Cyprus is that it is not an economic crisis, but a political one. If it was just about money, the Cyprus problem could be more easily solved. Many analysts who see the crisis as financial or economic in nature may be underestimating the depth of the problem in Cyprus. It needs a “mere” 16 billion euros to shore up its banks and prevent total collapse of its banking sector and economy. This is a fraction of the total 440 billion euros in the European Financial Stability Fund, the main source of funds for ensuring stability in the euro zone. In comparison, Greece, after three bailouts, has sucked up more than 240 billion euros from the troika – the EU, European Central Bank and International Monetary Fund.

Instead, the main sticking point of the bailout has focused on the need for Cyprus to raise its share of the total funds needed to get the bailout. Under the terms of the bailout, Cyprus needs to raise 5.8 billion euros to qualify for the 10 billion euros that would be loaned.

EU members, especially Germany, have been insisting that help cannot come for free. After all, EU leaders have their own electorates to answer to. As French Finance Minister Pierre Moscovici put it: “To those who say we are strangling an entire people ... Cyprus is a casino economy that was on the brink of bankruptcy.”

Cyprus has long been associated with money laundering, particularly funds from super wealthy Russian oligarchs. Its banks are estimated to hold 126.4 billion euros in assets, seven times the size of its real economy. Russian companies and investors are estimated to hold US$31 billion of in Cyprus, said ratings agency Moody’s.

So the 40 per cent tax on deposits will hurt rich Russians hard. Many of these oligarchs are likely to be close to Russian President Vladimir Putin. Would they stand aside as they see their wealth slashed? Russian Prime Minister Dimitry Medvedev hinted that the Kremlin was deeply unhappy over the proposals to tax large deposits. “Frankly speaking, this looks like the confiscation of other people’s money,” he said last week.

Economics professor Steve Keen, from the University of Western Sydney, believes that Russia will retaliate against Europe by threatening to cut off gas supplies. “If you are going to target the Russians, and there’s President Putin acting under the image of the strongman of Russia, why would he not decide to shut down gas supplies to Germany until that was righted?” he said. 

The Cyprus incident shows, more than ever, that Europe’s problems are far from over. The money put out by the EU has so far been nothing but plasters over bleeding wounds. The high government debt levels will take years to bring down.

Portugal, Italy, Ireland, Greece and Spain have started to tighten their belts and boost growth rates. Last year, Italy recorded a budget deficit of 2.9 per cent of the country’s gross domestic product, the lowest since 2010. Likewise, Ireland also expects to leave the bailout programme by the end of this year, with Irish growth forecast at about 1.5 per cent.

These are meaningful small steps giving hope that things can right themselves. But it won’t happen soon. Europe still faces mass unemployment and social discontent. 

The Cyprus incident has brought a “risk-off” or a cautious tone to markets. At least for now, Asian equities could be hit, and there could be some effect on growth too. Bosses are also likely to remain cautious on their investment and hiring plans as long as uncertainty remains.

So yes, breathe a sigh of relief because the worst has been avoided. But make it a short one. This isn’t over, not by a long mile.