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Cyprus – Small Island, Big Precedents

The small island nation in the Eastern Mediterranean was never considered a systemic risk for the euro, but the precedents set there could be critical.

The country was weathering the global financial crisis quite well during the first years. A first blow came from an explosion that occurred in the summer of 2011 near a power plant. Half of the island’s electricity supply was shut down.

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The bigger blows came from Greece. Cyprus has an oversized banking sector, but it probably could have been able to continue on the same path had the banks not invested heavily in Greece. Private Greek bondholders first suffered the so called “Private Sector Involvement“ (PSI) in March 2012 and then the bond buyback late in 2012. This put the major Cypriot banks in deep trouble.

The previous government received a loan from Russia and wasn’t eager on receiving a bailout from the EU. The new government led by Nicos Anastasiades already moved forward with negotiations and on the weekend of March 16th reached an agreement which shocked the world.

As part of the bailout program, the EU decided to tap into bank accounts: of all sizes and at all banks. The original plan sought to tax 6.7% out of accounts up to 100,000 euros, and 9.9% of bigger accounts.

This decision contradicts the EU rules that state that accounts of up to 100K are insured, guaranteed – safe.

European leaders insisted that Cyprus is a “special case“ and that its business model has to change. The opposition in Germany criticized the government for working on a bailout for Cyprus, which was seen by many as a bailout for Russian oligarchs – the special ones.

The president tried to have the parliament approve the measure in an emergency session. The backlash resulted in an extended bank closure beyond the bank holiday of March 18th. Eventually the parliament in Nicosia rejected the program and Cyprus returned to negotiations.

The agreement of March 25th already limited the losses to accounts over 100K and only at the two troubled banks. This is a more fair decision, but the damage has been done.

And while markets were looking for clarity regarding the details of the deal, the relatively fresh head of the Eurogroup explained in detail what would happen in the next bank bailouts – solutions that seem very similar to the Cypriot solution.

He later backtracked his words, rejecting the words “model” or “template”. Other leaders followed and repeated the stance that Cyprus is special. But yet again, the damage has been done.

Banks have reopened in Cyprus and capital controls have been imposed. From the initial statement that these controls are planned for one week, a month or even months of closure are now possible.

And while some details about haircuts have been made, it’s unclear how much money is actually in the banks. There are rumors that money has fled the country. In addition, there are allegations that a company owned by relatives of the president have squirreled away money before the bailout was announced.

During April, we will hopefully get a better picture of what’s going on in Cyprus.

After two weeks of crisis, there is a notion that:

  • Accounts under 100K are not 100% safe.
  • Depositors could participate in future bank bailouts
  • The European Union is not that unified: capital controls and “special cases” do not go hand in hand with the vision of the union.

ECB Reaction to Cyprus

The events in Cyprus haven’t been fully digested by Europeans. We could see gradual withdrawals out of banks, or at least a slower repayment of LTRO loans.

The ECB lent out around 1 trillion euros in two operations that occurred in December 2011 and February 2012. In recent months, banks have begun repaying these loans. This is a sign of better conditions and is akin to monetary tightening – a stronger euro.

The ECB reports the LTRO repayments every week. If the pace of these repayments grinds to a halt, there is a lot to worry about.

But can the ECB restore confidence after this blow? Can another statement by Draghi, such as “we will do everything to preserve the euro, and believe me, it will be enough” will be enough now?

Yohay Elam

Yohay Elam

Yohay Elam: Founder, Writer and Editor I have been into forex trading for over 5 years, and I share the experience that I have and the knowledge that I've accumulated. After taking a short course about forex. Like many forex traders, I've earned a significant share of my knowledge the hard way. Macroeconomics, the impact of news on the ever-moving currency markets and trading psychology have always fascinated me. Before founding Forex Crunch, I've worked as a programmer in various hi-tech companies. I have a B. Sc. in Computer Science from Ben Gurion University. Given this background, forex software has a relatively bigger share in the posts.