The Cyprus debt crisis: what it all means | David Taylor | Finance News Network

The Cyprus debt crisis: what it all means

by David Taylor

Special analysis: Making sense of Cyprus - What you need to know

Cyprus has been making headlines because it is an economic disaster. Its banking sector has failed. This is a quick, easy to digest analysis of what that means for you.

First, how does an economy ‘die’?

In the case of Cyprus, its business model, if you like, has failed. Its banks were heavily exposed to foreign capital: investments from both Greece and Russia. The state of the Greek economy has been well publicised so it’s easy to understand how Cypriat banks may have lost money there. In terms of Russia, well Cyprus is addicted to Russia. It’s understood a group of Russia’s investing elite use Cyprus to both launder money and use it as a tax haven. Therefore the country has been running on ‘dirty’ money for quite some time now.

About a week ago it came to a head when European finance ministers decided to draw a line in the sand. They canned the idea of 17 billion euro bailout and told Cyprus it would receive 10 billion euro instead, but it would need to raise the other 6-7 billion euro.

The first proposal was simply to tax depositors. That included slugging depositors with as a little as 20,000 euro in the bank with a 6 per cent levy. The bill was tabled in parliament but not one single MP voted in favour of it. That’s when things got nasty and Russia was brought into the equation.

The commentators started to speak up and say, ‘why on earth is the European Central Bank asking Cypriat deposit holders to pay for the mistakes of the banks?’  The answer: There were two key players calling the shots: Russia and Germany, and they have a score to settle. It was just bad luck for ordinary Cypriat deposit holders.

The German taxpayer’s fed up with supporting Cyprus. They were saying Greece is bad enough, but do we have to baby sit Cyprus as well?? They wanted to end it all and decided to refinance the government by taking money off Cypriat deposit holders and handing it to the banks. The key here is that the Germans were mainly looking to take money off the Russians (being very large Cypriat deposit holders) and clean up the banking system. Ordinary Cypriat deposit holders ended up being caught in the cross fire.  To add insult to injury the Cypriats are also too frightened to test the banking system to see if it still stands without the Russians.

The cat, as they say though, was out of the bag. Now the world knew the European Central Bank (and Germany’s) plan for Cyprus. It was to attack depositors and walk away from a potential euro zone financial disaster without taking any losses. By that I mean it could quite easily have written down the value of its debt holdings in Cyprus, but that clearly wasn’t going to wash with bank’s board. No, they were washing their hands of the problem and in so doing give the small island enough money to get by.

The rest of Europe heard that though and thought, bugger! If the European Central Bank’s idea of rescuing an economy in crisis is to target depositors, and avoid taking a financial hit of its own, what does that mean for other countries like Greece, Spain and Italy? Suddenly the potential for a widespread bank run was on. Would Cypriat deposit holders, and deposit holders in Greece and Spanish banks rush to withdraw money to avoid the government/European Central  Bank taking it first. Of course a bank run would also then lead to a financial contagion - an economic disaster big enough to bring about another global financial crisis.

The Cypriat government actually attempted to quash the problem by physically closing down the banking system and limiting the amount deposit holders could withdraw. The banks are still closed. Shops and businesses have responded by demanding that customers pay using only cash.

The only reason why the whole system hasn’t collapsed already is that the European Central Bank, along with the other lenders (which also comprise German interests) have allowed Cyprus to come up with a Plan B.

That plan, some of which has gone through parliament, involves two key aspects. First is the pooling of assets into a ‘solidarity investment fund’ – which will then be used as a legitimate investment vehicle to generate more money. The second is a banking overhaul which will involve making sure the banking sector has tighter and more secure capital controls, as well as a possible bank merger. It also looks like a Greek financial institution may buy one or two Cypriat banking assets in Greece.

Whichever way you cut it, the task for Cyprus has been straight forward: raise some cash, and European lenders will help you out. Cypriat deposit holders weren’t prepared to cough up the money so the government’s working out an alternative, and cleaning up the banking system in the process.

So is the problem solved?

The short answer is no. We now know the European Central Bank will consider attacking deposit holders when it wants to rescue an economy, and it’s now understood the European Central Bank cares more about its balance sheet than sparking a possible bank run.

And whether or not Cyprus will ultimately be successful this time around in cleaning up its economy is unclear. Nevertheless it’s still in danger of being kicked out of the euro zone altogether. The possibility of a near term bank run, and a financial contagion in the euro zone has now increased substantially.

From an Australian and global point of view, the position I’ve always had still stands. The risk of an economic shock that disrupts financial markets around the world is very real. At the moment, equity investors are being rewarded for taking on risk, but that may not always be the case.
 
David Taylor

Disclaimer

The content in my blog is non advisory, please do not interpret this as advice in any way shape or form. These are just my thoughts and nothing I say should be acted upon.