The European economic crisis
has taken different forms in different places, and Cyprus is the latest country
to face the prospect of financial ruin. Overextended banks in Cyprus are
teetering on the brink of failure for issuing loans they cannot repay, which
has prompted the tiny Mediterranean country, a member of the European Union, to
turn to Brussels for help. Late Sunday, the European Union and Cypriot
president announced new terms for a bailout that would provide the infusion of
cash necessary to prevent bankruptcies in Cyprus' banking sector and, more
important, prevent a banking panic from spreading to the rest of Europe.
What makes this crisis
different from the previous bailouts for Greece, Ireland or elsewhere are the
conditions Brussels has attached for its assistance. Due to circumstances
unique to Cyprus, namely the questionable origin of a large chunk of the
deposits in its now-stricken banking sector and that sector's small size
relative to the overall European economy, the European Union, led by Germany,
has taken a harder line with the country. Cyprus has few sources of capital
besides its capacity as a banking shelter, so Brussels required that the
country raise part of the necessary funds from its own banking sector --
possibly by seizing money from certain bank deposits and putting it toward the
bailout fund. The proposal has not yet been approved, but if enacted it would
undermine a formerly sacred principle of banking in most industrial nations --
the security of deposits -- setting a new and possibly destabilizing precedent
in Europe.
Cyprus' Dilemma
For years before the crisis,
Cyprus promoted itself as an offshore financial center by creating a tax
structure and banking rules that made depositing money in the country
attractive to foreigners. As a result, Cyprus' financial sector grew to dwarf
the rest of the Cypriot economy, accounting for about eight times the country's
annual gross domestic product and employing a substantial portion of the
nation's work force. A side effect of this strategy, however, was that if the
financial sector experienced problems, the rest of the domestic economy would
not be big enough to stabilize the banks without outside help.
Europe's economic crisis
spawned precisely those sorts of problems for the Cypriot banking sector. This
was not just a concern for Cyprus, though. Even though Cyprus' banking sector
is tiny relative to the rest of Europe's, one Cypriot bank defaulting on what
it owed other banks could put the whole European banking system in question,
and the last thing the European Union needs now is a crisis of confidence in
its banks.
The Cypriots were facing chaos
if their banks failed because the insurance system was insufficient to cover
the claims of depositors. For its part, the European Union could not risk the
financial contagion. But Brussels could not simply bail out the entire banking
system, both because of the precedent it would set and because the political
support for a total bailout wasn't there. This was particularly the case for
Germany, which would carry much of the financial burden and is preparing for
elections in September 2013 before an electorate that is increasingly hostile
to bailouts.
Even though the German public
may oppose the bailouts, it benefits immensely from what those bailouts
preserve. As I have pointed out many times, Germany is heavily dependent on
exports and the European Union is critical to those exports as a free trade
zone. Although Germany also imports a great deal from the rest of the bloc, a
break in the free trade zone would be catastrophic for the German economy. If all
imports were cut along with exports, Germany would still be devastated because
what it produces and exports and what it imports are very different things.
Germany could not absorb all its production and would experience massive
unemployment.
Currently, Germany's
unemployment rate is below 6 percent while Spain's is above 25 percent. An
exploding financial crisis would cut into consumption, which would particularly
hurt an export-dependent country like Germany. Berlin's posture through much of
the European economic crisis has been to pretend it is about to stop providing
assistance to other countries, but the fact is that doing so would inflict pain
on Germany, too. Germany will make its threats and its voters will be upset,
but in the end, the country would not be enjoying high employment if the crisis
got out of hand. So the German game is to constantly threaten to let someone
sink, while in the end doing whatever has to be done.
Cyprus was a place where
Germany could show its willingness to get tough but didn't carry any of the
risks that would arise in pushing a country such as Spain too hard, for
example. Cyprus' economy was small enough and its problems unique enough that
the rest of Europe could dismiss any measures taken against the country as a one-off.
Here was a case where the German position appears enormously more powerful than
usual. And in isolation, this is true -- if we ignore the question of what
conclusion the rest of Europe, and the world, draws from the treatment of
Cyprus.
A Firmer Line
Under German guidance, the
European Union made an extraordinary demand on the Cypriots. It demanded that a
tax be placed on deposits in the country's two largest banks. The tax would be
about 10 percent and would, under the initial terms, be applied to all
accounts, regardless of their size. This was an unprecedented solution. Since
the global financial crisis of the 1920s, all advanced industrial countries --
and many others -- had been operating on a fundamental principle that deposits
in banks were utterly secure. They were not regarded as bonds paying certain
interest, whose value would disappear if the bank failed. Deposits were
regarded as riskless placements of money, with the risk covered by deposit
insurance for smaller deposits, but in practical terms, guaranteed by the
national wealth.
This guarantee meant that
individual savings would be safe and that working capital parked by
corporations in a bank was safe as well. The alternative was not only
uncertainty, but also people hoarding cash and preventing it from entering the
financial system. It was necessary to have a secure place to put money so that
it was available for lending. The runs on banks in the 1920s and 1930s drove
home the need for total security for deposits.
Brussels demanded that the
bailout for Cypriot banks be partly paid for by depositors in those banks. That
demand essentially violated the social contract on the sanctity of bank
deposits and did so in a country that was a member of the European Union -- one
of the world's major economic blocs. Proponents of the measure pointed out that
many of the depositors were not Cypriot nationals but rather foreigners, many
of whom were Russian. Moreover, it was suggested that the only reason for a
Russian to be putting money in a Cypriot bank was to get it out of Russia, and
the only motive for that had to be nefarious. It followed that the confiscation
was not targeted against ordinary people but against shady Russians.
There is no question that
there are shady Russians putting money into Cyprus. But ordinary Cypriots had
their money in the same banks and so did many Cypriot and foreign companies,
including European companies, who were doing business in Cyprus and need money
for payroll and so on. The proposal might look like an attempt to seize Russian
money, but it would pinch the bank accounts of all Cypriots as well as a
sizable amount of legitimate Russian money. Confiscating 10 percent of all
deposits could devastate individuals and the overall economy and likely would
prompt companies operating in Cyprus to move their cash elsewhere. The measure
would have been devastating and the Cypriot parliament rejected it.
Another deal, the one
currently up for approval, tried to mitigate the problem but still broke the
social contract. Accounts smaller than 100,000 euros (about $128,000) would not
be touched. However, accounts larger than 100,000 euros would be taxed at an
uncertain rate, currently estimated at 20 percent, while bondholders would lose
up to 40 percent. These numbers will likely shift again, but assuming they are
close to the final figures, depositors putting money into banks beyond this
amount are at risk depending on the financial condition of the bank.
The impact on Cyprus is more
than Russian mafia money being taxed. All corporations doing business in Cyprus
could have 20 percent of their operating cash seized. Regardless of precisely
how the Cypriot banking system is restructured, the fact is that the European
Union demanded that Cyprus seize portions of bank accounts from large
depositors. From a business' perspective, 100,000 euros is not all that much
when you are running a supermarket or a car dealership or a construction
company, but this arbitrary level could easily be raised in the future and the
mere existence of the measure will make attracting investment more difficult.
A New Precedent
The more significant
development was the fact that the European Union has now made it official
policy, under certain circumstances, to encourage member states to seize
depositors' assets to pay for the stabilization of financial institutions. To
put it simply, if you are a business, the safety of your money in a bank
depends on the bank's financial condition and the political considerations of
the European Union. What had been a haven -- no risk and minimal returns -- now
has minimal returns and unknown risks. Brussels' emphasis that this was mostly
Russian money is not assuring, either. More than just Russian money stands to
be taken for the bailout fund if the new policy is approved. Moreover, the
point of the global banking system is that money is safe wherever it is
deposited. Europe has other money centers, like Luxembourg, where the financial
system outstrips gross domestic product. There are no problems there right now,
but as we have learned, the European Union is an uncertain place. If Russian
deposits can be seized in Nicosia, why not American deposits in Luxembourg?
This was why it was so
important to emphasize the potentially criminal nature of the Russian deposits
and to downplay the effect on ordinary law-abiding Cypriots. Brussels has
worked very hard to make the Cyprus case seem unique and non-replicable: Cyprus
is small and its banking system attracted criminals, so the principle that
deposits in banks are secure doesn't necessarily apply there. Another way to
look at it is that an EU member, like some other members of the bloc, could not
guarantee the solvency of its banks so Brussels forced the country to seize
deposits in order to receive help stabilizing the system. Viewed that way, the
European Union has established a new option for itself in dealing with
depositors in troubled banks, and that principle now applies to all of Europe,
particularly to those countries with financial institutions potentially facing
similar problems.
The question, of course, is
whether foreign depositors in European banks will accept that Cyprus was one of
a kind. If they decide that it isn't obvious, then foreign corporations -- and
even European corporations -- could start pulling at least part of their cash
out of European banks and putting it elsewhere. They can minimize the amount of
cash on hand in Europe by shifting to non-European banks and transferring as
needed. Those withdrawals, if they occur, could create a massive liquidity
crisis in Europe. At the very least, every reasonable CFO will now assume that
the risk in Europe has risen and that an eye needs to be kept on the financial
health of institutions where they have deposits. In Europe, depositing money in
a bank is no longer a no-brainer.
Now we must ask ourselves why
the Germans would have created this risk. One answer is that they were
confident they could convince depositors that Cyprus was one of a kind and not
to be repeated. The other answer was that they had no choice. The first
explanation was undermined March 25, when Eurogroup President Jeroen
Dijsselbloem said that the model used in Cyprus could be used in future bank
bailouts. Locked in by an electorate that does not fully understand Germany's
vulnerability, the German government decided it had to take a hard line on
Cyprus regardless of risk. Or Germany may be preparing a new strategy for the
management of the European financial crisis. The banking system in Europe is
too big to salvage if it comes to a serious crisis. Any solution will involve
the loss of depositors' money. Contemplating that concept could lead to a run
on banks that would trigger the crisis Europe fears. Solving a crisis and
guaranteeing depositors may be seen as having impossible consequences. Setting
the precedent in Cyprus has the advantage of not appearing to be a precedent.
It's not clear what the
Germans or the EU negotiators are thinking, and all these theories are
speculative. What is certain is that an EU country, facing a crisis in its
financial system, is now weighing whether to pay for that crisis by seizing depositors'
money. And with that, the Europeans have broken a barrier that has been in
place since the 1930s. They didn't do that casually and they didn't do that
because they wanted to. But they did it.
George Friedman,
Founder and Chairman, Stratfor, March 26, 2013
"Europe's Disturbing Precedent in the Cyprus Bailout is republished with
permission of Stratfor."
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