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Broke If You Do, Broke If You Don’t.

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It’s the song that never ends. Country’s troubled banking system is in turmoil, government can’t issue bonds to refinance it, country asks for emergency funding. Group of lenders respond with a half thought out, utterly noxious proposal sure to jeopardize the economic and political position of the nation’s government. Political crisis abounds, poor economic precedent set, fears of contagion permeate European market. Now we’d all like to think that the fiscal fallout from the mishandled Greek restructuring would be enough for the “Troika” to get it right this time, but evidently no one in Brussels has the courage to call German austerity hawks out for their lack of vision. Never before has a national legislature been asked to consider a proposal that not only is an affront to that essential citizen-government trust needed to legitimize modern currency systems, but blatantly ignores the economic realities of the nation it governs.

Are we surprised that the Cypriots refused to adopt a plan to tax depositors accounts when the bulk of their financial strength lies in their sheltering billions in foreign deposits? Who gambles what solvency remains for a sum that barely covers one-eighth of the assets in their banks, much less the capital sure to be lost from taxing accounts that exist to avoid taxation? The depositor tax condition forces the Cypriot government to risk bankruptcy regardless of whether it accepts the bailout terms. Furthermore, the proposal sets a dangerous precedent for the other heavily indebted financial sectors across Europe and is sure to galvanize renewed fears of “contagion,” effectively reversing prior successes achieved by earlier rescue efforts.

And It Goes On And On My Friends

The deal is one of the worst we’ve seen in the various chapters of this Eurozone mess. To receive €10 billion in emergency funds, the Cypriot government needed to raise €5.8 billion in collateral, and with government bond issuance off the table (given it’s junk rating since 2011) the deposit tax proposal was introduced as the most expedient way to amass those funds. On its face the proposal appears founded on financial logic since the tax would be a one-off and the bulk of Cypriot bank assets were depositor savings. The government imposes the tax at 6.75 percent for accounts with less than €100,000 9.9 percent for accounts over that sum, and exemptions could be made for depositors with fewer than €20,000 in the bank. But the arrangement has several, rather obvious, concerns.

While it’s true that Cypriot financial institutions are capitalized primarily by deposits, the underlying reason behind that is Cyprus’ role as a haven for individuals (especially Russians), who want to keep their funds from being taxed. Cypriot banks have long flourished as tax-free shelters for foreign assets, so to suddenly tax these assets endangers their primary source of capital, and any lending operations contingent on that capital. Should foreign deposits start to move elsewhere, once Cypriot banks are open next Tuesday, we’ll be adding undercapitalization and liquidity crises to the list of problems for Cyprus’ financial system.

The proposal also ignores the close links between Cyprus and Greece, who would be directly affected by shocks in the financial markets of its primary import-export partner. According to World FactBook data, 21 percent of Greek exports make their way to Cypriot ports, and the merchant shipping industry is the most profitable in Greece. Also, we can’t forget that Cyprus’ two largest banks, the Bank of Cyprus Group (BOC) and Cyprus Popular Bank (CPB) still have fairly extensive operations in Greece, and that Cyprus needed €2.5 billion in emergency funds after the losses incurred from Greece’s debt restructuring in October of 2011. Should Cyprus formally declare bankruptcy, the aftereffects in an already struggling Greece could destroy what economic strength is left in that economy and touch off a new crisis.

Lastly, there are political concerns from the proposed depositor tax. Cypriot banks are closed until next Tuesday because the mention of such a tax touched off a run on both BOC and CPB. Even with the measure defeated in their parliament, there’s no guarantee that the extended bank holiday will allow the government enough time to find the financing it needs to stave off the insolvency of its banks, much less the €14 billion in government debt. There’s a real chance that we could see further withdrawals from both foreign and domestic accounts and fears of bankruptcy take hold which will only deepen the political crisis sure to follow. Also we can’t exclude the possibility that such a condition could be replayed on a Greek, Italian, Spanish, or Portuguese stage as all four will more than likely need continued help to sort out their debt concerns. Given the ECB’s reluctance to step into the fray and take charge, the Eurozone couldn’t abide that kind of shock.

It Just Keeps Getting Better And Better

As if there weren’t enough problems in this story, the biggest issue is that the bailout package is entirely too small to handle the billions of euros held by Cyprus’ bloated banking system. Ironically enough, the Cypriot’s role as a tax shelter and their banks appetite for deposits has weakened the financial system instead of strengthening it. The Cypriot government has long shied away from any serious financial oversight, giving their banks a wide berth to attract foreign capital but at the cost of failing to recognize problematic lending practices and act to soften the blow dealt by the Greek restructuring deal in 2011.

It’s hard to say what politicians in Nicosia actually knew about their financial system’s condition, but it’s clear that their “light touch” approach allowed Bank of Cyprus and Cyprus Popular to accumulate risk and mushroom into two massive institutions with holdings several times greater than the rest of the economy. With over €85 billion in assets the pair of banks holdings are worth 4.6 times the nations GDP, and much of the €16.82 billion in non-deposit accounts is tied up in toxic Greek debt and bonds from its own central bank. Speaking of that, we have to say a thing or two about Cypriot sovereign debt which has grown around €2 billion annually since 2010 and stands at a cool €15 billion or 81 percent of GDP.

The emergency bailout package calls for a fresh infusion of 10 billion euros after a 5.8 billion euro capital raise, but €10 billion isn’t enough to deal with any one of Cyprus’ underlying financial woes, much less the set exacerbated by a bank run and liquidity crisis thereafter. Cypriot banks are holding €64.8 billion in deposits, of which €26.4 billion are held by foreign depositors (€15.4 billion by Russian clients alone) and fear of the tax has already stoked the coals enough to cause lines outside of teller machines. To make matters worse, the EU-IMF-ECB coalition is near-requiring the tax as a condition for emergency funding not to mention yesterday’s ultimatum delivered by the European leadership giving Cyprus 96 hours to make a deal. Either way you look, a Cypriot bankruptcy is a real possibility and unless new, better terms reach the table (what’s that about snowballs in hot places?) the ensuing bank run will silence the Cypriot economy.

Of Geese And Ganders

There are some who might argue that the effects of bankruptcy in Nicosia are insignificant to the broader European economy given Cyprus’ diminutive stature within the Eurozone and the preponderance of Russian assets in Cypriot banks. However, that position understates the impact of the conundrum that it is this financing deal and that side’s been wrong before.

Analysts on that side made the same predictions about Greece for nearly three years and as the European Union trudged their way to the deal Athens ultimately got, four other nations (including Cyprus) had fallen ill to the sovereign debt “contagion.” The problematic resolution of Greece fueled the flames that subsequently sent Italy to new elections, threw Spain into 24 percent unemployment, and kick started demonstrations in Lisbon. Particularly the more debt laden in the Eurozone, this depositor tax is ominous because Spain, Greece, Italy, and Portugal aren’t out of the woods yet. Should any of these four request additional aid, which is likely, such a tax proposal could lie in wait for them and none of the four needs the social, economic, or political unrest that would follow.

If Cyprus is the guinea pig for this financial pilot program and things sour, global markets will be watching and reacting. This will be especially true if international banks with holdings in Cypriot banks have to take a haircut as they did in Greece. As we saw with Greece, and thanks again to their interconnected financial fortunes, a Cypriot default wouldn’t be contained to Nicosia, or even Athens after that. Had the EU Commission, ECB, and IMF concerned themselves with recovery and reform instead of reprimands and discipline, markets might have viewed a distressed Cyprus as an isolated incident. Greece proved that the Eurozone is treated as the unit it’s supposed to be and contagion is sure to abound anew should similar tax provisions come on later packages for nations like Spain or Italy.

Last Words

At this point, there’s not much doubt in my mind that Cyprus won’t end up defaulting entirely but there’s also no doubt that crisis could have been averted. Cyprus is a good example of why governments must be active  in banking, and the dangers posed by massive financial institutions incurring losses no one sees until it’s too late. It also highlights the unnecessarily obstinate and short-sighted policy-making from austerity hawks in Brussels, whose obsession with clandestine penalizing costs the entire currency union credibility it can’t afford to lose. Recovery, reform, and growth need to take precedence over principled punishment to get the Eurozone back on its feet.

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About Alexander J Smith III