Been meaning to post about Cyprus for awhile now…the details have obviously been in the news for a few days now so apologies if this is rehashing what’s already been said:
It basically looks like Cyprus followed the island banking model of Iceland and Ireland before it—lax domestic regulation and low taxation allowed massive growth in the financial sector—Cyprus became somewhat of a depositors paradise, and in the run-up to the 2008 financial crisis enjoyed high growth, low unemployment, and a decent public financial outlook (relatively low budget deficit and debt-to-GDP ratio).
The Cypriot banking system eventually ran up assets worth ~800% of Cyprus’ GDP; thus, when things went south in 08 the entire financial sector was in big trouble. This is where things get interesting—it turns out that the structural elements underlying the Cypriot banking system differed a bit from the situation in Ireland and Iceland—
First, Cyprus banks (in aggregate) issued a very small amount of debt—their liabilities are almost entirely composed of deposits. Thus, any ‘bail-in’ (rescue funding requiring some contribution from creditors of the institutions being rescued) inevitably would involve contributions from depositors (as shareholders in the banks would be wiped out very quickly).
Second, it appears that a hefty share of the deposits in the Cypriot banking system came from Russian individuals who were using Cyprus as an off-shore tax and banking haven of sorts. Cypriot banks then used these deposits to fund the purchase of Greek bonds; of course, when creditors took a loss when Greece restructured their debt as part of the emergency funding they received from the EU, this left a massive hole in the balance sheets of the Cypriot banks, leading to the current woes.
Thus, Cyprus stands in need of ~17 billion Euros. In an agreement worked out over the weekend/early this week, the EU agreed to provide $10 billion Euros in emergency funding; in return, Cyprus had to engage in the typical ‘structural reforms’ (aka austerity) and come up with a mechanism to raise the rest of the money from bank creditors. For some reason unbeknownst to me, the final plan ended up being a tax on deposits; 6.75% on accounts under 100,000 euro, ~10% on accounts over 100,000 euro.
The Cyprus deposit tax is a terrible policy outcome. In essence, it completely undermines the EU deposit insurance—if I am a depositor in Spain or Italy, and I have previously been promised that all of my money (up to 100,000) is safe, and all of a sudden regular folks in Cyprus have to pay 6.75% on their deposits to bail out the banks, I sure as hell am moving my money to the UK or Germany.
I’ve read a lot about why this policy outcome occurred over the past few days, but I have to admit I am still stumped—I understand that Germany has an election coming up, and the bailout is only palatable to Germans if Germany can impose harsh austerity and demand that creditors in Cyprus shoulder a significant burden of the bailout. I understand that Cyprus wants to preserve its status as an off-shore tax/financial haven, and if it sets the levy on deposits over 100,000 too high (or implements some other scheme like converting deposits over 100,000 to 5-year CD’s that would lock the money in the country for a matter of years) that might be impossible. However, I just cannot fathom why anyone would allow a plan to move forward that undermines the newly created insurance deposit scheme—it is really not that difficult for the core countries to understand that this could spark a contagion that would be much more damaging than the .12% of Euro-zone GDP that Cyprus requires in bailout funds…I guess we’ll see how this plays out (as of now it looks like Cyprus will reject the deposit levy and seek assistance from Russia)—even if the deposit tax is never implemented, I can’t help but wonder if the mere fact that it arose as a possibility will be the spark that ignites fiscal flight in the peripheral Eurozone countries.