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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 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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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: [email protected] 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
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
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.
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.