Island Banking

The Cyprus story continues to evolve; first, though, a couple of updates to the posts from yesterday: I mentioned that the EU (really, the EU, ECB, and IMF together) would loan Cyprus $10 billion euros if Cyprus could come up with the remaining $7 billion of the necessary $17 billion euros through a revenue-raising scheme (the deposit tax). Based on reports I’ve seen today, it looks as if the actual amount that Cyprus had to raise was $5.8 billion euros.

Krugman has a nice piece on what went wrong in Cyprus (everything that could); he also makes the astute point that even if Cyprus gets through the next several days without a total collapse of the banking system, it’s not at all clear how they are going to emerge from this mess in the medium term without leaving the Euro—their real estate collapse has yet to fully unwind (which will hinder growth moving forward); their banking system is in total disarray (not completely unrelated to the real estate bubble); their economic competitiveness has declined over the past decade, and without their primary export industry (banking), it is not clear how they are going to generate any growth at all in the private sector over the next several years. To top it off, (and this is a point I probably should have made more explicit yesterday), Cyprus’ public debt has risen significantly over the last few years, and in exchange for emergency liquidity from the ECB and loans from the EU, their government will have to engage in massive austerity at precisely the time it should be counterbalancing the massive private sector contraction that will occur over the next 2-3 years.

Felix Salmon makes the excellent point that Cyprus going to Russia or anyone else for a loan instead of moving ahead with the original plan to tax deposits isn’t really an option—in exchange for the EU loan, Cyprus needs to begin immediately reducing their debt to GDP ratio, which means 1) Cyprus needs to make up the rest of the monetary shortfall in immediate revenue and 2) the government will have little to no room to counteract private sector shortfalls moving forward. I think the only way out of this for Cyprus without taxing deposits or leaving the Euro involves essentially licensing/selling the rights to future offshore natural gas drilling and/or revenue in exchange for immediate cash– (that is, unless the EU is willing to let Cyprus’ public debt exceed the legal limit). Update: looks like Russia won’t play ball with Cyprus–its EU bailout/deposit tax or bust for Cyprus.

Once Cyprus realizes that their status as an off-shore banking haven is pretty much gone, it’s not entirely clear to me what the best course of action is for Cyprus–leaving the Euro would probably be extremely damaging in the short-run; however, having their own (devalued) currency and independent monetary policy again might be the best possibility for Cyprus medium to long term. Of course, if Cyprus does leave the Euro, that would almost certainly spark a massive run on sovereign debt/banks in the Euro periphery, which would be a pretty bad outcome for everyone still on the Euro, so if I had to guess, I would say the likelihood of that happening is very low. Of course, I never would have expected a deposit tax on deposits under 100k to be floated as a serious proposal either…

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