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Cypriot Bungled Bailout Matters

Posted by Steve Markowitz on March 30, 2013

The European Union’s first bailout attempt of Cyprus was a dismal failure.  That plan included a tax on all bank deposits that was rejected by the Cypriot Parliament.  A more recent deal scraps the tax on depositors, but will still include losses for depositors and bondholders.

Cyprus’s largest bank, Laiki Bank, will be wound down with major bondholders taking losses.  In addition, depositors with over €100,000 will be penalized.  Some of Laiki Bank’s debt will be moved over to the Bank of Cyprus, the country’s largest lender, which will survive after the bailout.  However, many Bank of Cyprus depositors facing losses over 50% of their assets.  Since this will not be a tax it does not require Cypriot parliamentary approval.

Cyprus is a meager part of the European Union’s GDP, less than 1% with less than 1 million residents.  The banking crisis became a much larger problem for Europe for two reasons.  First, Cypriot banks became haven for foreign investors, mainly Russian making its banks eight times larger than the entire economic output of Cyprus.  In addition, as part of the European Union, allowing it to implode risk contagion to other peripheral EU countries.  Finally, it should be noted that the Cypriot banks took huge losses and became insolvent because of its holdings of Greek sovereign bonds, another EU basket-case.

While Cyprus’s is an insignificant piece of the European Union’s economy, the way the crisis has been “resolved” will likely lead to huge consequences for Europe going forward.  Unlike in other EU bailouts, Cypriot depositors were forced to take haircuts on deposits.  This brings into question an issue not raised in Western banks since the Great Depression; the safety of deposits.  If the issue is contained to Cyprus, it will be insignificant.  However, it is only a matter of time before depositors in other weak European countries become concerned about the safety of their bank deposits.  This will lead to a run on those banks.  Prime candidates are Italy and Spain, countries that are indeed “too big to fail”, but at the same time the EU does not have the assets to bail them out.

The bailout of Cyprus is reported to cost the EU less than $10 billion.  Given this relatively small amount as compared to the total European Union GDP, why have they risked so much for the future of the larger EU banking system?  The answer is political.  Germans voters are wary of the bailouts of weaker neighbors and Andrea Merkel’s party faces an election.  This tough approach to Cyprus is designed to mollify German voters.  However, in the long run it places much more at risk for European unity.

Another interesting question is why the fiscally conservative Germany remains part of the European Union with its many weaker and fiscally irresponsible partner countries.  The answer is self-interest.  Germany is much more efficient than its southern partners.  In previous years these countries could have lowered the value of their currency to become competitive against Germany.  With the creation of the Euro, the cost of products from these inefficient countries has risen compared to Germany’s products.  Is not surprising, therefore, that while Spain’s unemployment rate is currently 25%, Germany is a mere 6%.  While the cost of the bailouts for Germany is high, the cost of dissolving the European Union would be even higher.

With the template of the Cypriot bailout in place, the EU has made it policy that under some circumstances it will demand member states seize depositor assets as a price for bailing out its banks.  The message for depositors in European peripheral countries is clear; should banks in your country become financially at risk, your deposits will also become at risk.  Human nature demands action of these depositors.  Depositor funds will move from weaker countries to stronger ones, thereby exasperating the already existing financial strain on weaker European countries’ banks.  This has the makings of Europe’s next banking crisis and it will be the result of self-inflicted wounds.

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