Last night the finance ministers of the eurozone decided on a bailout package for Cyprus. The small country with around 1 million inhabitants has an overstretched banking sector that is in dire straits. The primary reason for this is that the Cypriotic banks hold a lot of Greek sovereign debt – debt that took a serious haircut a few months ago when the EU decided that holders of Greek bonds would only receive 60% of their money. Cypriotic banks have been sympathetic (and maybe under pressure from the ECB) and have loaded up on Greek bonds. This is the primary reason for the trouble in Cyprus. The rest of the economy (GDP per capita, debt, etc.) is around average for a euro country.
But because the banks are stuffed to the gills with Greek bonds that are now only worth 60 cents on the dollar they need a bailout.
The big problem for the government is that the banking sector is extremely large in comparison to how small an economy Cyprus is. This is partly due to the fact that the island has always been a bit of a tax haven, with sympathetic banks and a corporate tax rate of 10%, the lowest in the eurozone. This means that the government is unable to bail out the banks. They just don’t have that kind of money. This is why The IMF and the ECB has stepped in and bailed out the banks. Rumor has it that without the bailout Cyprus two largest banks would be bankrupt in a matter of days. A situation no economy can survive, especially not one with a disproportionally large banking sector.
The bailout, as usual, comes from the other Euro countries through the ESM flanked by the IMF.
Cyprus is a small economy (around 0.2% of the Eurozone), and bailing out its banking sector is cheap compared to Spain, Italy and even Greece. But since the EU and thus the Euro is basically a political construct a bailout has to make political sense as well as economic sense. Unfortunately sometimes the two seem to be two mutually exclusive. As in this case.
The terms of the bailout are that all funds in Cypriotic banks will be subject ot a one-time tax of 9.9% (6,75% for accounts holding less than €100.000) This tax is being withdrawn immediately from every Cypriotic bank account over the weekend. Everyone with a bankaccount in Cyprus will find that when they when the banks open on tuesday (monday is funnily enough a bank holiday) there will be less money than there was on friday. This goes for everyone, from instutional investors, private savers, checking accounts and pensioners. If you had a lot of money saved up for your retirement stashed away in a Cypriotic bank, well bad luck for you because on tuesday only 90% of it will be there.
What happened after this was announced was entirely predictable. A bankrun. People are currently lining up outside ATM’s to get their money out before they’re taxed. The response from central hold has been to close down all electronic banking and not restock ATM’s so people can’t get their money out before tuesday when the tax has been withdrawn from the accounts.
Bankruns are what every economist, policymaker and banker fear the most. The whole banking system is based on trust, if even 10% of customers withdraw their cash from a bank it will be bankrupt in matter of hours. No bank has the money in its vault to pay up if everyone wants their money at the same time. This is a vicious circle – when there is even the smallest doubt about a banks solvency some people will begin to pull their money. When people begin to pull their money everyone else will follow, knowing that the last one in line won’t get a dime. This is why most countries have a state-backed insurance in the case of bank bankruptcies. Even if the bank goes down the state will pay you the money you had in your account. It is paramount for an economy that people trust that their money is safe in the bank no matter what happens.
This whole thing is entirely unfair for the people living in Cyprus. The average citizen had nothing to do with the banking sector stocking up on Greek debt, but now they have to pay for it. The reason, apparently, being that the other Euro members , headed by Germany, think it would be fair that the southern nations learn to pay for their excesses instead of relying on bailouts from the Northern countries. An assessment that is, at best, inaccurate.
The result is that the Euro areas finance ministers have shown that freezing all bank accounts in a country and withdrawing 10% without warning is a tool they’re willing to use. They’re calling it a one-off and promise it won’t happen again, but it’s a large crack in the faith of the Europen banking system, and it sends a clear signal to all savers, companies and investors in the Eurozone: If you have funds in banks in a troubled euro country there’s a chance it will be taxed without warning. You could wake up one day and see that your €1 million has shrunk to €100.000 overnight. What does it matter that our money is federally insured against bankruptcy, if the state can just decide to take it away from one day to the next?
So what do investors, businesses, and savvy savers do? They pull their money from banks in the troubled euro countries. No need to take the risk, even if it’s small.
In other words: Because of the idiotic idea that the Cypriotic people should pay for the bailout of their banks by simply taking 10% of the funds in every single account in the country the market now knows that money isn’t safe in troubled eurozone banks.
Don’t be surprised to see a bankrun in Greece, Spain, Italy or Portugal next week.
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I agree with the main thrust of your post. However I think you need to disclose two additional important facts to make this story stand out more.
Half of Cyrpus bank deposits are for Russian nationals that have used this country and banking system to essentially launder money. Taking 10% of them is actually a good move.
The second lesser point is that for more than 99% of locals, the rate of confiscation is 6.5% not 10%. Less than 1% have 100K euros deposits in any given account…
You’re right, and I presume a lot of the rationale behind this move was to hit Russian money launders. The fallout, however, is huge and I just don’t understand how a policymaker that knows the slightest bit about economics could think this is a good idea.
Your second point btw. also points to the theory that the goal was to hit Russian money launders.
Well informed reports elsewhere say that some of the banks in Cyprus are Russian, and are not subject to this haircut. The reports that say half the money in Cypriot banks is Russian do not distinguish how much of that money is actually in the Cypriot banks that are subject to this Cypriot tax. See:
It does not matter if it is 1%, 6.5% or 0.001% with more than 100.000K in the bank, nor does the actual confiscation rate.
What matters is the principal that a non written tabu for 100s of years was broken with basically instructing a sovereign government to confiscate money from personal bank and savings accounts from legit tax payers of this country.
The ECB backed by the IMF intents to get the country economically back on track with bailing out the banking system which caused the misery in the first place. But how do they intent to get back their 10b if most corporates, private individuals and also the Russian money laundering machine gladly pays their 9.9% (6.5%) and 1 day later transfers billions into accounts in the Cayman Islands, Channel Islands or wherever, simply for the reason, that politicians cannot be trusted in their promises. (haven’t they promised them once, that their money is safe in their banks??)
Who steals the dime, will not hesitate to steal the dollar, regardless of their promises.
the far better option would have been, 12b from the ECB 6.5% – 12% on high interest investment equity. 3% for regular saving accounts exceeding 150k.
I do have offshore company with Cyprus company current account. Does this tax also affects my company?
Yes, Cypress Hill will get your 10% to further their inventory of blunts.
Great writeup and analysis!
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The function of the central bank is to rescue a bank in need. Not the tax payer. If the tax payer is bailing out individual banks, why do we give the monopoly to create debt money without liability to a private entity like a central bank? Then just end the central bank and be consistent, let the state bring the money into circulation.
“This whole thing is entirely unfair for the people living in Cyprus. The average citizen had nothing to do with the banking sector stocking up on Greek debt, but now they have to pay for it.”
True – and false. As you said yourself, the state don’t have 7 billion € stashed away, so the state needed to find them elsewhere. And part of the reason they didn’t have them was lack of taxes. You (again) said it. Corporate taxes are being raised from 10 to 12%.
It is the same average citizens that year in and year out have elected a government that chose not to raise taxes. Now that average citizenry is paying the price for their own stupidity.
Well, playing Devil’s Advocate, those with most to gain from a bank bailout would be those who would otherwise lose their savings in a bank collapse, i.e. depositors. So, why therefore, should they not contribute more than the average taxpayer in the bailout through a levy like this ?
I broadly agree with your post and think that a run on the banks is the worst possible outcome and inevitable with this approach. The whole episode has been handled incompetently and can only lead to further instability.