Cyprus Bailout: A big risk for Europe (and the World)

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On Saturday the 16th of March, in an economic bailout plan supported by the EU and the IMF, the deposits in Cypriots banks were frozen. Additionally, in an unprecedented move, a percentage of those …

On Saturday the 16th of March, in an economic bailout plan supported by the EU and the IMF, the deposits in Cypriots banks were frozen. Additionally, in an unprecedented move, a percentage of those private deposits (held both by common people and business) will be seized to “help” repay some of the amount of the bailout. If you have followed the recent story of the crises in Latin America or have suffered from its consequences, this episode of the European crisis may seem terribly familiar. In this brief analysis if the Cyprus bailout I review some of the possible implications for the European Union and the world. I will argue that the conditions of the bailout create an extremely dangerous precedent for the rest of the countries in Europe, especially for Spain, Greece, Italy and Portugal. Three days after the announcement, as the protests in Cyprus and concern in the rest of Europe were increasing, it seemed that some aspects of the bailout plan could change, but even if that happens the negative effects could spillover beyond Cyprus

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  • 1. Cyprus:  Big  mistakes,  new  troubles.  And  why  it  matters  for  the  EU  (and  the  rest  of  the  World)   Julio  J.  Prado,  PhD(c)     Lancaster  University  Management  School  (UK)   IDE  Business  School  (Ecuador)   E-­‐mail:  pradojj@gmail.com   Twitter:  @pradojj          On  Saturday  the  16th  of  March,  in  an  economic  bailout  plan  supported  by  the  EU  and  the   IMF,   the   deposits   in   Cypriots   banks   were   frozen.   Additionally,   in   an  unprecedented   move,   a   percentage   of   those   private   deposits   (held   both   by   common  people   and   business)   will   be   seized   to   “help”   repay   some   of   the   amount   of   the  bailout.  If  you  have  followed  the  recent  story  of  the  crises  in  Latin  America  or  have  suffered   from   its   consequences,   this   episode   of   the   European   crisis   may   seem  terribly   familiar.   In   this   brief   analysis   if   the   Cyprus   bailout   I   review   some   of   the  possible   implications   for   the   European   Union   and   the   world.   I   will   argue   that   the  conditions  of  the  bailout  create  an  extremely  dangerous  precedent  for  the  rest  of  the  countries  in  Europe,  especially  for  Spain,  Greece,  Italy  and  Portugal.  Three  days  after  the  announcement,  as  the  protests  in  Cyprus  and  concern  in  the  rest  of  Europe  were  increasing,   it   seemed   that   some   aspects   of   the   bailout   plan   could   change,   but   even   if  that  happens  the  negative  effects  could  spillover  beyond  Cyprus.        After  almost  five  years  of  an  ongoing  European  crisis,  we  are  all  pretty  much  aware  of  the  problems  that  the  European  Union  is  facing.  No  clear  economic  policy  can  be  applied;  no  straightforward  solution  exists.  The  only  thing  we  can  give,  as  external  
  • 2. Cyprus:  Big  mistakes,  new  troubles  March  2013     Julio  J.  Prado  observers,   are   some   ideas   of   whether   a   policy   will   be   mainly   positive   or   mainly  negative.   If   there   is   something   we   have   learned   from   the   Great   Recession   is   that  both  orthodox  and  heterodox  tools  have  failed  to  provide  a  solution,  and  it  is  easy  to  point   the   finger   to   those   that   now   have   the   problem   in   their   hands.     Nevertheless,  there  are  some  policy  decisions  that  are  mistaken  and  may  deepen  and  prolong  the  crisis.  In  my  opinion,    this  is  the  case  of  the  recent  bailout  plan  in  Cyprus.  Here  are  some  ideas  (this  is  not  intended  to  be  a  comprehensive  analysis):     1) The  banks  have  been  the  cornerstone  of  the  European  crisis.  For  reasons  that   I   will   not   cover   in   this   analysis,   the   roots   of   the   current   crisis   can   be   easily   traced   back   to   the   easing   of   the   lending   conditions   (e.g.   reductions   in   the   financial  regulations),  to  high  levels  of  private  and  public  debt,  and  to  some   unethical   practices   not   only   from   politicians   but   also   by   private   bankers.   Thus,   most   of   the   efforts   from   the   European   Union   authorities   focused   on   restructuring   the   banking   sector   (e.g.   increasing   banking   capitalization),   while   injecting   more   money   to   the   economy   (through   banks   or   public   spending)  in  order  to  restart  growth  and  reduce  the  chronic  unemployment.       The   recent   bailout   in   Cyprus   goes   in   the   same   line,   and   comes   with   similar   though  austerity  measures  that  need  to  be  implemented  in  order  to  receive   the   money   transfer,   but   the   case   of   Cyprus   goes   even   further   since   it   introduces  for  the  first  time  a  levy  on  all  the  private  savings.    The  “tax”  will  be   equivalent  to  9.9%  of  the  total  savings  amount  if  the  value  exceeds  100.000   euros,  and  6.75%  if  the  amount  is  below  that  value.       2) Now,   it   might   seem   reasonable   to   assume   that   if   the   Cypriots   are   going   to   receive   a   hefty   loan   (10   billion   euros)   from   the   EU,   they   will   have   to   contribute  something  in  order  to  repay  the  loan.  After,  I  can  be  argued  that   even   if   it   is   easy   to   pinpoint   the   culpability   of   the   crisis   to   politicians   and   bankers,   the   common   people   from   Cyprus   (the   households,   the   consumers,   the   ordinary   common   man)   are   also   guilty   in   some   degree.   Although   I   do   not   endorse  this  argument,  I  understand  why  many  people  especially  in  Germany   might  support  it.  Granted!  But  this  is  not  the  focal  point  of  discussion,  what   we  should  be  discussing  is  whether  the  conditions  of  this  bailout  are  the  best   (are  the  fairest)  for  Cypriots  and  ALSO  for  the  future  of  the  European  Union   and  the  German  tax  payers  (who  are  directly  and  indirectly  involved  in  this   bailout).    My  argument  is  that,  the  conditions  of  the  bailout  are  not  fair  and   economically  dangerous  for  the  Cypriot  economy,  and  even  more  perilous  for   the  other  countries  in  Europe.  Yes,  including  Germany.       3) Cyprus   has   a   highly   informal   economy.   The   easing   of   the   regulations   in   the   banking   sector   attracted   a   large   number   of   money   inflows   from   Russia   (including   a   public   credit   of   2,5   billion   euros).   According   to   some   reports,   these   capital   inflows   may   be   related   to   illegal   activities   or   more   simply,   tax   avoidance.   Clearly   the   9,9%   tax   to   deposits   that   are   higher   that   100.000   euros   would   target   most   of   these,   which   could   be   seen   a   “fair”   and   even   have   a   large   support   from   the   public.   (As   I   will   argue   next,   even   targeting   those  
  • 3. Cyprus:  Big  mistakes,  new  troubles  March  2013     Julio  J.  Prado   large  accounts  is  dangerous.)  But  remember  there  is  also  a  levy  of  6.75%  to   deposits  smaller  than  100.000  euros.  This  part  of  the  bailout  is  not  so  easy  to   defend   in   terms   of   an   “evenhanded   contribution”   since   it   hits   the   large   majority   of   Cypriots,   those   that   have   already   been   suffering   by   the   European   Crisis  for  the  last  five  years.  It  targets,  small  and  large  households,  students,   small   entrepreneurs   equally.   Now,   a   6,75%   could   be   considered   a   small   amount   that   will   not   destabilize   someone’s   personal   finance   but   it   is   still   a   confiscation   of   private   accounts,   and   in   some   cases   this   could   but   some   family  savings  in  peril.       4) The  Cypriot  bailout  plan  breaks  at  least  two  (unspoken)  rules.  First,  ordinary   people   savings’   were   not   to   be   touched.   Secondly,   investment   banks   had   to   take   some   of   the   blame   in   case   of   the   financial   crisis.     It   is   widely   agreed   that   investment   banks,   those   that   gamble   in   the   financial   markets   using   complicated   financial   operation   (credit   default   swaps,   mortgage   backed   securities,  options,  money  arbitrage,  etc),  should  not  be  saved  in  case  of  the   financial   crisis.   Their   business   implies   risk,   but   this   is   supposed   to   be   a   calculated  risk,  thus  if  they  earn  a  lot  of  money  that  is  fine,  and  if  they  loose  a   lot  of  money  that  is  also  fine.  It  is  their  business.  The  honest  truth  is  that  the   investment   banks   have   been   highly   spoiled   and   protected   both   in   the   USA   and  the  EU,  but  this  new  Cypriot  bailout  is  a  brand  new  way  of  passing  all  the   harsh  consequences  of  the  crisis  to  the  commons  and  nothing  to  the  banks.       5) The  impact  at  the  level  of  ordinary  people  is  clear.  Why  is  it  so  bad  for  the  EU   as   a   whole?   The   name   of   the   word   is   confidence.   Confidence   is   what   keeps   the  economic  systems  alive  or  what  destroys  them.  Sadly,  the  EU  is  trying  to   restore   confidence   in   the   financial   sector   by   injecting   more   money   into   the   Cypriot  economy,  but  under  these  conditions  the  confidence  is   eroded.  Think   as  if  this  were  your  money.  What  would  you  do  after  this  storm  has  passed?   Would   you   go   and   leave   your   deposits   again   in   the   bank?   What   if   Cypriot   economy  needs  a  new  bailout  in  the  future?  The  panic  this  could  generate  is   immense  and  creates  a  long  and  persisting  damage  to  the  confidence.       6) EU   authorities   are   trying   to   reassure   this   was   the   only   way   out   for   Cyprus.   More   importantly,   they   are   reassuring   that   something   like   this   would   not   happen  in  any  other  country  in  Europe.  In  the  light  of  the  recent  events  are   these   statements   credible?   Portugal,   Italy,   Spain   and   Greece   may   need   new   credits   from   the   EU   during   the   next   months.   By   remembering   the   case   of   Cyprus,   the   simple   announcement   of   the   negotiations   for   a   bailout   may   trigger   bank   runs,   resulting   in   more   fragile   banking   systems   in   Southern   Europe.  Nobody  wins  from  a  higher  volatility  and  uncertainty  in  the  financial   sector.   The   contagion   of   uncertainty   could   even   backslash   to   the   Germanic   economy  and  to  the  whole  European  Union  as  the  recent  decline  in  the  Euro   versus  the  dollar  is  showing.      
  • 4. Cyprus:  Big  mistakes,  new  troubles  March  2013     Julio  J.  Prado   7) Finally,   the   support   of   the   IMF   opens   a   series   of   questions   regarding   the   future  of  economic  policy  in  a  downturn.  It  is  one  thing  to  hear  that  a  country   –on  its  own-­‐  is  seizing  deposits  or  applying  similar  measures.  It  would  even   be  understandable  that  the  EU  would  make  such  a  proposition  for  one  of  its   members,  but  the  IMF  backing  up  such  a  measure  open  a  whole  new  level  of   intervention  in  the  future.  Not  only  for  European  Countries,  but  for  the  world   as   whole.   It   might   sound   exaggerated   since   Cyprus   is   a   very   small   country   and   the   effects   of   the   bailout   seem   localized,   but   the   signals   and   negative   incentives   this   bailout   is   sending   will   have   a   large   spillover   effect.   Maybe   larger  than  the  EU/IMF  authorities  care  to  admit.       8) In  the  eve  of  the  year  1999,  Ecuador  was  in  the  middle  of  the  worst  economic   crisis  the  country  had  ever  seen.  During  a  weekend,  all  bank  accounts  were   frozen   to   prevent   a   “bigger   economic   meltdown”.   Half   of   the   total   of   each   current   and   savings   accounts   remained   frozen   for   several   months.   While   long-­‐term  savings,  repos  and  investments  remained  frozen  for  one  year.  The   situation  for  ordinary  people  and  business  was  desperate  and  less  than  one   year   later   (January   2000)   Ecuador   had   to   abandon   its   own   currency   and   adopt   the   dollar   as   the   only   legal   currency   (exchange   rate   of   25.000   sucres   per  dollar).  The  abrupt  transition  into  the  full  dollarization  scheme  was  long   and   painful,   producing   a   high   economic   volatility   and   political   turmoil,   but   the  tight  self-­‐imposed  conditions  (the  dollarization  is  a  strict  fixed  exchange   rate   regime,   in   which   monetary   policy   is   almost   obsolete)   finally   brought   stability   and   growth.   Contrary   to   the   case   of   Cyprus,   no   obligatory   amount   was   seized   by   the   Government   (although   the   real   value   of   the   deposits   was   highly   depreciated   or   lost   during   the   resulting   banking   crisis).   The   case   of   Cyprus   may   be   equally   difficult.   After   the   banking   freeze   had   been   (partially)   removed  in  Ecuador,  there  was  an  exceptionally  high  risk  of  a  stampede  and   a   new   collapse   of   the   remaining   banks,   the   only   thing   that   prevented   this   from  happening  was  the  dollarization  scheme.  Is  there  such  a  mechanism  in   the   Cypriot   economy?   Of   course,   that   country’s   currency   is   the   euro,   which   is   a   strong   currency,   so   there   is   no   incentive   to   abandon   it,   except   if   the   Government  authorities  were  forced  to  devalue.  After  the  freezing  is  over,  if   the  confidence  in  Cypriot  banks  has  not  returned,  the  EU  will  have  a  though   decision  to  make.  Keep  sending  money  (another  bailout)  or  leaving  Cyprus  to   its  own  faith.  Cyprus  is  a  small  economy  so  the  contagion  effect  will  not  come   from  that  side.  Nevertheless,  as  I  have  pointed  earlier,  there  are  many  other   possible  spillovers  that  could  affect  the  EU  in  other  ways.      The  case  of  Cyprus  is  unfortunate    and  sends  the  wrong  signs.  A  poor  handling  from  the   EU,   the   IMF   and   the   Government   has   created   a   solution   that   is   worst   than   the  problem.   Is   this   just   another   act   in   the   EU   crisis   drama,   or   are   we   witnessing   the  beginning  of  a  new  genre  of  policy…and  tribulations?  We  will  know  soon.