Cyprus – A Solution That Makes The Problem Worse

What kind of a solution is it that makes the initial problem worse??? According to the details so far available, Cyprus is to effectively close one of its banks – Laiki Bank – and transfer the deposits of its savers with less than €100,000 to its other bank – The Bank Of Cyprus. In other words, they will create a bad bank, using Laiki Bank. The deposits under €100,000, therefore, now in The Bank of Cyprus, will be secured under the European Bank Deposit Guarantee. Deposits in The Bank of Cyprus over €100,000 will face a levy, possibly at a rate of 4%, some time in the future. In the short term, the deposits in Laiki Bank will face a levy of around 40%!!!!

The consequences of this are fairly predictable. Anyone who has lost 40% of their money deposited in Laiki Bank, is going to remove the rest as soon as capital controls are relaxed. That other 60% represents a considerable sum of money still. It means the original problem facing Cypriot Banks, of lack of liquidity will be made worse. Laiki Bank will then go bust. That means any other banks with exposure to it will be hit. British Banks are reported to have exposure of about €1 billion.

But, that also means that Cyprus will then need to go back to the EU and IMF for even more money to deal with the crisis that will ensue from that. Anyone, with money in The Bank of Cyprus or any other Cypriot Bank, seeing the inevitability of that will also be getting their money out in full as soon as possible, because if the 40% haircut on deposits in Laiki Bank is not enough, resolution of the further crisis will inevitably mean coming back for more of depositors money, and it will be unavoidable to take deposits under €100,000.

Given that one of the problems identified was the fact that Cypriot Banks had deposits equal to 8 times GDP, the consequence of such an inevitable large scale capital flight are obvious. Cyprus GDP is $22.5 billion. That means current deposits are around $170 billion. If we assume these deposits are split fairly equally between Laiki and Bank of Cyprus, then we would likely see $50 billion withdrawn from Laiki Bank, and pretty much all of the $85 billion in Bank of Cyprus. Preventing that means that capital controls would have to be in place for some considerable time. The longer they are in place, the more a lingering death will occur, as depositors take out what they can, whilst no one in their right mind will put money in.

The continuation of capital controls for any length of time will also cripple the Cypriot economy, because it means business cannot function. What business would risk having its payments paid into a bank account under these conditions? In fact, if you were considering buying a house in Cyprus why would you. If the house cost more than €100,000 you would risk losing nearly half that payment simply during the conveyancing process, as the payment went through the banks!!!! But, it also means that uncertainty and fear is increased across Europe, because the question must then be, who will be next, where next will such capital controls be imposed?

The answer to those last questions seems to be Luxembourg and other tax havens like the Channel Islands, as I pointed out – After Cyprus, Who's Next?.

But, if Cyprus then needs around €130 billion to cover the capital flight, how is that a solution for a problem that originally only required €17 billion? In the meantime its likely to turn Cyprus into a pre-banking economy, causing effectively a credit crunch of mammoth proportions, within Cyprus. That may be capable of being contained within Cyprus, but the contagion of fear, and the effect of large numbers of people removing their money from banks across Europe, and particularly from those tax havens cannot. Given the extent of exposure of Luxembourg, nobody in their right mind is going to leave their money in its banks, above or below the €100,000 limit.

There is no shortage of tax havens around the globe, where the problems associated with tax havens in the Eurozone do not exist. In fact, had Cyprus wanted to really build its economy around being such a tax haven, it would have been well advised to have stayed out of the Euro, and to have stuck with the Cyprus Pound. A tiny economy like Cyprus, could easily on that basis have dealt with its problems by simply printing the currency it needed to meet immediate liquidity needs, in a way that an economy like Greece could not.

It may be too late for Cyprus to follow that route now, but that does not stop money moving to those places that have. Apart from Switzerland, that is bad news for many of the smaller EU economies.