What happened?
It’s simple. Cypriot banks ran out of money.
When this sort of thing happens, the national government will generally stump up the cash but the government didn’t have that sort of money. In which case, the sovereign bank (like the Federal Reserve or the Bank of England) would generate the money, which is an inflationary risk of course but it keeps the wheels turning.
But as Cyprus is a member of the Euro, this could not be. The European Commision, the European Central Bank and the International Monetary Fund, (the Troika) effectively refused to step in. I understand why – the banking debts alone were well over the Cypriot GDP and a number of Eurozone governments would not sanction this, even if direct injection of funds into banks were allowed. The subtext was an anathema towards tax havens in Berlin. Time for a lesson.
Part of the reason for this debacle was the situation in Greece. As Greece tottered towards meltdown, investors in Greek bonds saw their investments marked down 50%. Cypriot banks had invested heavily in Greece for cultural reasons. So not everything was the fault of the tax haven they were building.
The Cypriot government ran out of money to guarantee depositors and nobody would lend it to them. The best they could get was a €10bn loan from the ECB and IMF, contingent on finding further money from austerity – that word again. They were caught between a rock and a hard place and to raise this, proposed a relatively small ‘tax’ on all deposits.
This ran up against understandable opposition from depositors, who would lose 6.75% on deposits up to €100,000 and 9.99% above that. Within the Eurozone, deposits are guaranteed up to €100k by diktat so this could not be, even though the ECB would not back up the mandated guarantee, a very odd position to take indeed.
So the government decided to close the Laiki bank, transferring the first €100k of accounts to the Bank of Cyprus and freezing any remainder. Bank of Cyprus account holders will be similarly treated but that bank is not being closed. Balances over €100k will be part of what it called a bail-in – some part – maybe 60% – will be converted from (liquid) money to (illiquid) shares in the bank. Imagine how much they will be worth. Other parts will be available with or without interest. The total proportions are not entirely clear at the moment. Other banks are not affected.
That’s it. In two words, legitimised theft.
When these things happen it is like dominoes, just as the failure of the Cypriot banks is in part a result of the Greek haircut. Except the further repercussions in this case has cynically fallen entirely on the shoulders of ordinary and innocent Cypriots. This should, I am sure was the calculation, mean that the ‘contagion’ would not spread to other parts of the Eurozone.
Does this matter to ordinary folk? You bet.
If you had money for a rainy day, had transferred it from a pension fund, saved for your children, were buying a house or having to pay staff, suddenly you can’t. Ordinary folk who have jobs may have not get paid. Shops that can’t pay for goods or order more goods will become empty. Cash will be the only currency; Cyprus will become a zombie state.
But there are further implications. Investors will be very wary of a currency which does not have proper banking discipline. Yields – the interest charged by investors particularly to the embattled southern European countries – will rise. Increased yields mean it will become more difficult to recover from the worlds financial mess.
But more. If nothing over €100k is safe in Eurozone banks, depositors will put their money elsewhere. Expect commodities to rise, other currencies too. Some Eurozone banks may become short of money and hence insolvent. So the whole thing will start again.
It is a complete mess and a botched plan.
Whose fault was that?
Three parties really – the Troika, the banks themselves and the Cypriot politicians.
- The Troika was not able to support the banks, nor try. Mario Draghi’s pronouncement last year that he would do anything to support the Euro clearly included impoverishing one of the 17 countries;
- Cypriot financial services that had indulged in tax-haven operations including risky lending particularly to Greece;
- Cypriot politicians who failed to regulate the financial industry properly – not unknown elsewhere – and the recently elected government mandated to stay in the Euro whatever the cost. Taking that negotiating position to Frankfurt was a disaster – the ECB held all the cards.
What should have happened?
- Faced with the obduracy of the Troika, Cyprus should have been prepared to leave the Euro by restoring the Cypriot pound. This would have led to substantial devaluation but, as Iceland has shown (and Iceland’s banks were in a worse position than Cyprus’ banks), recovery is possible if and only if you have sovereign currency control;
- If the political judgement was taken that remaining on the Euro was sacrosanct, all deposits over €100k should have been affected. It is patently unfair that one depositor would lose almost all their money while their neighbour who had the good luck to be with another bank lost nothing.
- Not enough was done to look for assistance from outside the Eurozone. While Moscow was particularly unhelpful, we should remember that the UK retains sovereign military bases on the island – including listening posts essential in the fight against terrorism. Even if Cyprus never approached the UK government, the latter could well have offered, much as it made a £3bn soft loan to Ireland during the latter’s troubles. All this of course may have annoyed the ECB. Good.
Can it happen elsewhere?
Particularly in the Eurozone, yes because of the absence of proper banking regulation and oversight. But it is only likely in a small country far away from the seats of power. Imagine the amount of manure that would be spread around by farmers if a French bank failed and no help was forthcoming!
The reason why Cyprus was dumped on from a great height is that it is far away, there aren’t too many tractors in Cyprus and the small matter of the Mediterranean. Cyprus has been stitched up pour encourager les autres.
Outside the Eurozone, it is highly unlikely. Even when RBS and HBOS almost failed in the UK, (the former being only a few hours away from running out of cash), Northern Rock and Bradford and Bingley were nationalised, no-one lost their money. The government of the day and the Bank of England reacted properly. This has left the UK taxpayer with a huge burden but banks are still working.
There were similar actions taken elsewhere – the US taxpayer’s support of the Bank of America springs to mind, as does the federal takeover of Fannie Mae and Freddie Mac. The raw fact is that the price of a banking failure these days is too much for any government to contemplate so action would be taken by the sovereign currency. This was not done – and because of its design, not strictly possible – for Cyprus.
Key to this (a view from a non-specialist) is ” The raw fact is that the price of a banking failure these days is too much for any government to contemplate”.
This does not fill me with confidence and I feel the need to get as self-sufficient and least dependent on banking of any sort as possible.
Banking is fine, Pat, as long as it is properly run.
We really have little alternative other than to become entirely self-sufficient, growing food, building our own houses etc. This may suit some people – and of course would lead to a resurgence of real food which would not do any harm at all = but it will end up turning us back to the stone age as education, science, arts etc would all become luxuries.
When will the guilty parties suffer? Never I guess!
I doubt that the architects of the common currency will ever get taken to court, even though it was an ill-thought out scheme. There is of course the cynical interpretation that the fallibility of the Euro was a plot aimed at forcing banking union, followed by fiscal then full political union down the throats of an unwilling EZ public. Financial collapse was therefore a (very early) trigger for this.
I subscribe more to the cock-up theory that it was romantic nonsense. Either way, you are right – and anyway Kohl and Mitterand, the pair who pushed the whole project through, are no longer on the scene. I sympathise with the horrors they saw as young men but their solution was a political answer to a banking problem.
I imagine the Greek, Italian, etc are also withdrawing their money to avoid suffering the same thing. So unfair that the savers are being punished instead of the spenders.
Portuguese too, Pauline. Good friends of ours in Manchester are from Portugal and their stories are horrific. The doctors have no work because, from a position of free health care, people now have to pay to see the doctor or have anything done. So many are living on 500EUR a month while costs have gone up.
Always very interesting to pose macro situations to potential micro ones. Great post, and great insight especially to legitimized theft.
Great post, John. I think you’re absolutely right that destroying confidence in the currency will augur a vicious cycle for Cyprus.
It’s interesting that you attribute no blame to investors, who have known all about the compensation ceilings in place. Savers in Laiki Bank UK have been massively fortunate that the PRA have intervened on their behalf to ship their funds to the Bank of Cyprus. But hopefully they’ll learn a quick lesson to keep investments in any one bank to a maximum of £85K/€100K.
I take the point that, without somebody to penalise, it wasn’t a solution. But, put brutally, it’s the careless who have put themselves in the position of liability to cover the cost of this fiasco. Is that a fair way to put it? Even so, is that a fair solution? It’s a moral shambles for Europe, one way or another.
@Keith – I didn’t address investor blame because I suspect the majority of people with >€100k are small savers and businesses who are really innocent parties.
But you are right that they should have known in principle. Then, if they had substantially more than €100k, where could they put it? There aren’t that many banks in Cyprus and I don’t know whether a Cypriot could open an account in a German bank for example – I suspect not without an address in Germany.
Laiki UK depositors have been very lucky. It was touch and go as I understand.
Of course we now have the spectacle that Slovenia and Malta in particular could be next along the line. These all fit the pattern of small Euro members who can be bullied without too many tractors. At least Slovenia is not far from Frankfurt.
The worrying thing now is that the bailin has climbed from about €7bn to €13bn and it is becoming impossible for Cyprus to recover. Where on earth will they get that sort of money from? All the big depositors managed to extract their money before the brown stuff hit the fan. The bailin will probably increase to 100% on Laiki and BoC depositors and I think trying to touch depositors in any foreign bank located in Cyprus will be a very hot potato.
So I think the probability of a Cyprus exit from the Euro has increased quite a bit – basically they will have to find €23bn on their own or possibly default which will be the less painful way for Cyprus itself. The Troika seems unwilling to help.
Germany has profited enormously from the cheap Euro – full factories and order books. The Bundesbank essentially wrote the recipe for the Euro and it made enormous errors. George Soros is right – there must be Eurobonds issued and Merkel will have to climb off her pedestal even at electoral cost. So I was absolutely spot on when I wrote almost a year ago now about this in Who would be Angela Merkel.
George Soros was also right in his recent speech. He knows a thing or two I think. His recipe is for Eurobonds – or Germany must leave the Euro and let the rest of the countries get on with it. The alternative is many years of stagnation and increasing division, conflict etc. Not noice at all.