After a week of turmoil in Cyprus (see the News item Ochi, ochi, ochi) a deal has been struck between Cyprus, the EU and the IMF over a €10bn bailout for the island’s banking system. But while the deal may bring the immediate crisis to an end, the Cypriot economy could face years of austerity and depression. And there remain questions over whether the deal sends the wrong message to depositors in banks in other eurozone countries whose banking systems are under pressure.
Unlike the original EU proposal, the deal will not impose a levy on deposits under €100,000, much to the relief of small and medium depositors. But individuals and businesses with deposits over €100,000 in the two main troubled banks (Laiki and the Bank of Cyprus) will face losses that could be as high as 40%. The precise size will become clear in the coming days.
The troubled second largest bank, Laiki (Popular) Bank, will be split into a ‘good’ and a ‘bad’ bank. The assets and liabilities of the good part will be taken over by the largest bank, the Bank of Cyprus. Thus people’s accounts under €100,000 will be moved from one to the other. The ‘bad’ part will include deposits over €100,000 and bonds. Holders of these could lose a substantial proportion of their value.
Many businesses will be hard hit and may be forced to close. This could have serious adverse multiplier effects on the economy. These effects will be aggravated by the fiscal austerity measures which are also part of the deal. The measures are also likely to discourage further inward investment, again pushing the economy further into recession.
And then there are the broader effects on the eurozone. The direct effect of a decline in the Cypriot economy would be tiny; the Cypriot economy accounts for a mere 0.2% of eurozone GDP. Also the effect on small savers in other eurozone countries is also likely to be limited, as people will probably be reassured that savings under €100,000 have remained protected, even in an economy as troubled as Cyprus.
But some commentators argue that the effect on large depositors in other troubled eurozone countries, such as Portugal, Spain, Greece and Italy, could be much more serious. Would people with large balances in these countries prefer to move their money to, say, Germany, or even out of the eurozone altogether? There is clearly disagreement over this last point as you will see from the articles below.
Webcasts and Podcasts
Cyprus agrees bailout with eurozone ministers The Guardian (25/3/13)
Cyprus bailout: Deal reached in Eurogroup talks BBC News (25/3/13)
‘Disaster avoided’ as Cyprus agrees EU bailout deal Euronews (25/3/13)
Cyprus saved from bankruptcy Channel 4 News on YouTube, Faisal Islam (25/3/13)
What are the implications of the Cyprus deal? BBC Radio 4 Today Programme, Stephanie Flanders (25/3/13)
Cyprus bailout deal: Russia riled but Germany relieved BBC News, Steve Rosenberg in Moscow and Stephen Evans in Berlin (25/3/13)
Cyprus bailout deal ‘durable’ says IMF chief BBC News, Christine Lagarde (25/3/13)
Cyprus Bailout Deal Raises Questions: Lombardi Bloomberg, Domenico Lombardi (25/3/13)
Minister Michalis Sarris: Cyprus paying ‘tremendous cost’ BBC Radio 4 Today Programme, Michalis Sarris (26/3/13)
Articles
Last-minute Cyprus deal to close bank, force losses Reuters, Jan Strupczewski and Annika Breidthardt (25/3/13)
Cyprus strikes last-minute EU bailout deal The Guardian, Ian Traynor (25/3/13)
‘There is no future here in Cyprus’ The Telegraph, Nick Squires (25/3/13)
Back from the brink: EU ministers approve €10bn bailout deal at 11th-hour to save Cyprus Independent, Charlotte McDonald-Gibson and Majid Mohamed (25/3/13)
Cyprus bailout: Deal reached in Eurogroup talks BBC News (25/3/13)
Q&A: Cyprus deal BBC News (25/3/13)
The rescue of Cyprus won’t feel like one to its people BBC News, Robert Peston (25/3/13)
Lessons of Cyprus BBC News, Stephanie Flanders (25/3/13)
Cyprus bailout: Dijsselbloem remarks alarm markets BBC News (25/3/13)
Cyprus saved – but at what cost? The Guardian, Helena Smith (25/3/13)
Cyprus bail-out: savers will be raided to save euro in future crisis, says eurozone chief The Telegraph, Bruno Waterfield (25/3/13)
Cyprus’s banks have been tamed – are Malta and Luxembourg next? The Guardian, Ian Traynor (25/3/13)
Lehman lessons weigh on Cyprus talks but 1920s slump must not be ignored The Guardian, Larry Elliott (24/3/13)
Questions
- Explain what is meant by ‘moral hazard’. What moral hazards are implicit in the deal that has been struck with Cyprus?
- How does the size of the banking system in Cyprus as a proportion of GDP differ from that in other troubled eurozone countries? How does this affect the ‘contagion’ argument?
- Does the experience of Iceland and its troubled banks suggest that the Cypriot problem has nothing to do with its being in the eurozone?
- What options are open to the Cypriot government to stimulate the economy and prevent a severe recession? How realistic are these options (if any)?
- What are the likely implications of the deal for the economic relationships (as opposed to the political ones) between Cyprus and Russia and between the eurozone and Russia?
- Are there any similarities in the relationships between the weak and strong eurozone countries today and those between Germany and other countries in the 1920s and 30s?
Banks in Cyprus are in crisis. They have many bad debts e.g. to Greece and as mortgages in a falling property market. Private-sector debts have become unsustainable for the banks. The problem is compounded by negative economic growth and large government deficits (see chart). But, as with Icelandic banks back in 2008, this means a crisis for the whole country.
The reason is that the banking sector in Cyprus, as in Iceland and Ireland too, is large relative to the whole economy – over 8 times annual GDP (second only to Ireland in the EU). Loans to Greece alone are as much as 160% of Cyprus’ GDP and Cypriot banks were badly hit by the terms of the Greek bailout, which required creditors to take a 53% reduction (or ‘haircut’) in the value of their loans to Greece. With such a large banking sector, it is impossible for the Cypriot government alone to rescue the banks.
Cyprus thus turned to the EU for a bailout: back in June 2012. This makes Cyprus the fifth country to seek a bailout (after Greece, Ireland, Portugal and Spain). A bailout of €10 billion has just been agreed by the EU and IMF. The bailout comes with the ‘usual’ conditions of strong austerity measures of tax rises and cuts in government expenditure. But what makes this bailout different from those given to the other countries was a proposed levy on savers.
The proposal was that people with up €99,999 in their bank accounts (of any type) would face a one-off tax of 6.75%. The rate for those with €100,000 or more would be 9.9%, including on the first €99,999. This would raise around €5.8 billion of the €10 billion.
Not surprisingly, there was a public outcry in Cyprus. People had thought that their deposits were protected (at least up to €100,000). There was a run on cash machines, which, as a result were set to deliver just small amounts of cash to cope with the excessive demand. There was huge pressure on the Cypriot government not to introduce the measure.
But the ramifications of the proposed levy go well beyond the question of justice to savers. Questions are being raised about its incentive/disincentive effects. If people in other countries in future financial difficulties felt that they might face similar levies, how would they behave? Also, there is no haircut being proposed for holders of banks’ bonds. As Robert Peston states in his first article below:
The Cypriot deal sets back the cause of the new global rules for bringing order to banking systems when crisis hits. Apart from anything else, in other eurozone countries where banks are weak, it licenses runs on those banks, as and when a bailout looms.
But getting incentives right is not easy. As the Buttonwood column in The Economist points out:
The problem is tied up with the issue of moral hazard. This can be applied to both creditors and debtors; the former should be punished for reckless lending and the latter for living beyond their means. The collapse of Lehman Brothers is seen as an example of the faulty reasoning behind moral hazard; by letting the bank go bust, the crisis was spread throughout the financial system. But rescuing every creditor (or intervening to bail out the markets every time they falter) is the reason we are in this mess.
One alternative considered by the Cyprus parliament was to exempt people with less than €20,000 in their accounts from the levy. But this was rejected as being insufficient protection for savers. Another is to exempt people with less than €100,000, or to charge people with between €20,000 and €100,000 at a lower rate or rates.
But charging less, or nothing, on deposits of less than €100,000 would make it harder to to raise the €5.8 billion required by the EU. Without alternative measures it would mean charging a rate higher than 9.9% on larger deposits. The Cypriot government is afraid that this would discourage inward investment. Russia, in particular, has invested heavily in the Cyprus economy and Russia is campaigning vigorously to limit the size of the levy on large deposits. But there is little sympathy for Russian depositors, much of whose deposits are claimed to be ‘laundered money’. The Cypriot government has been seeking financial support from the Russian government.
An alternative proposal being considered is to issue government bonds in an “investment solidarity fund” and to transfer pension funds from semi-public companies to the state. Also Russia may be willing to invest more money in Cyprus’ offshore oil and gas fields.
Agreement
A deal was struck between Cyprus and the EU/IMF early in the morning of 25 March, just hours before the deadline. For details, see the News Item Cyprus: one crisis ends; another begins.
Webcasts and podcasts
Eurozone ministers agree 10bn euro Cyprus bailout Channel 4 News (16/3/13)
Bailout is ‘blackmail’ claims Cyprus president Euronews (17/3/13)
Cyprus’s president tries to calm fears over EU bailout The Guardian (18/3/13)
Cypriot bank customers reactions to savings levy BBC News (17/3/13)
Cyprus bailout: Parliament postpones debate amid anger BBC News (17/3/13)
Cyprus parliament delays debate on EU bailout Al Jazeera (17/3/13)
Cyprus told it can amend bailout, as key vote postponed BBC News, Gavin Hewitt (18/3/13)
Robert Peston: Cyprus bailout an ‘astonishing mess’ BBC News, Robert Peston (18/3/13)
Cyprus bailout is ‘completely unfair’ BBC Radio 4 Today Programme, Michael Fuchs and Bernadette Segol (18/3/13)
Lenders ‘doing everything you should not do’ on Cyprus BBC Radio 4 Today Programme, Alistair Darling (19/3/12)
Cyprus warned over bailout rejection BBC News (20/3/13)
Articles
Cyprus becomes fifth eurozone bailout The News International (Pakistan) (17/3/13)
Cyprus bailout deal sparks run on ATMs Irish Independent (17/3/13)
EU leaders gamble in Cyprus bank bailout BBC News, Gavin Hewitt (17/3/13)
Cyprus told it can amend bailout, as key vote postponed BBC News (18/3/13)
Q&A: Cyprus bailout BBC News (19/3/13)
Cyprus’ President Defends Bailout Deal The Motley Fool (16/3/13)
Sad Cyprus The Economist, Buttonwood’s Notebook (12/3/13)
The Cypriot bail-out: A fifth bitter lemon The Economist (30/6/12)
Analysis: Cyprus bank levy risks dangerous euro zone precedent Reuters, Mike Peacock (17/3/13)
The Cyprus precedent Reuters, Felix Salmon (17/3/13)
The Cyprus Bank Bailout Could Be A Disastrous Precedent: They’re Reneging On Government Deposit Insurance Forbes, Tim Worstall (16/3/13)
Cyprus rescue breaks all the rules BBC News, Robert Peston (18/3/13)
Cyprus and the eurozone’s survival BBC News, Robert Peston (20/3/13)
Eurogroup defends Cyprus bail-out The Telegraph (17/3/13)
Cyprus eurozone bailout prompts anger as savers hand over possible 10% levy The Guardian (16/3/13)
Cyprus’s wealth tax makes perfect sense – its rich won’t escape unscathed The Guardian, Phillip Inman (18/3/13)
The tragedy of Cyprus The Real Economy blog, Edmund Conway (16/3/13)
Damage limitation in Cyprus BBC News, Stephanie Flanders (19/3/13)
The fatal flaw in the eurozone’s not-so-cunning plan for Cyprus The Guardian, Larry Elliott (19/3/13)
Cyprus plans special fund in race to get EU-IMF bailout BBC News, (21/3/13)
Cyprus says ‘significant progress’ in debt crisis talks BBC News (23/3/13)
Background information
The Banking System in Cyprus: Time to Rethink the Business Model? Cyprus Economic Policy Review, Vol. 5, No. 2, pp. 123–130, Constantinos Stephanou (2011)
European sovereign-debt crisis Wikipedia
Questions
- What is the justification given by the Cypriot government and the EU for imposing a levy on bank deposits?
- What alternative measures could have been demanded by the EU? Why weren’t they?
- What is the significance of Russian deposits in Cypriot banks?
- Compare the benefits of the proposed levy rates with the alternative of imposing levies only on deposits over €100,000, but at higher rates (perhaps tiered).
- Explain the moral hazard issues in bailing out the Cypriot banks.
- How serious is the problem that imposing a tax on deposits in Cypriot banks might have adverse affects on the behaviour of depositors in other countries’ banks?
- How might Cypriots behave in future in regards to depositing money in banks? What impact could this have on the economy of Cyprus?
- Explain “the unholy trinity of options facing indebted nations (inflate, stagnate, default)”. Compare the effectiveness of each.
After a week of turmoil in Cyprus (see the News item Ochi, ochi, ochi) a deal has been struck between Cyprus, the EU and the IMF over a €10bn bailout for the island’s banking system. But while the deal may bring the immediate crisis to an end, the Cypriot economy could face years of austerity and depression. And there remain questions over whether the deal sends the wrong message to depositors in banks in other eurozone countries whose banking systems are under pressure.
Many businesses will be hard hit and may be forced to close. This could have serious adverse multiplier effects on the economy. These effects will be aggravated by the fiscal austerity measures which are also part of the deal. The measures are also likely to discourage further inward investment, again pushing the economy further into recession.