Pandora's Box: The Cyprus Story

Pandora’s Box: The Cyprus Story

Well here we are again, with yet another European country in financial distress and the ‘troika’ (European Commission, ECB, and the IMF) riding to the rescue. After a brief hiatus the ‘bailout bandwagon’ gets back on the road, and this time it’s Cyprus’s turn to go cap in hand to prevent it defaulting.

So how did Cyprus, a tiny country best known as a fantastic holiday destination, become the centre of a financial firestorm with far-reaching implications?

Its fate was effectively sealed when it joined the euro in 2008. Although it wasn’t in great financial shape at the time of joining, the imbalances in its financial system ballooned once it was effectively backed by the Euro rather than the Cypriot pound.

Over the five year period since joining, its bank assets have doubled, reaching an incredible eight times GDP and completely skewing the risk profile of the country. Money flooded in (much of it from the Russian mafia) attracted by low taxes, a relaxed attitude to banking regulations and the implied guarantee of euro membership. As a result of this flood of money, Cyprus became a major centre for tax evasion and money laundering. Awash in money, much of it ended up invested in Greek corporate and government debt, and when the Greeks effectively defaulted, this money went up in smoke and a Cypriot default became inevitable.

Now we know how the situation developed, let’s look at how the rescue deal was struck and why its ripples will spread much further than the Mediterranean.

 The original deal from the troika was to lend 10bn euros on the proviso that the Cypriots find the remaining 5.8bn euros by imposing a levy on bank deposits, part of which entailed depositors with 100,000 euros or less taking a 6.75% haircut.

Seeing that this would affect almost every voter in the country, create a huge political storm, and probably result in them being thrown out of office, the politicians did exactly what we would expect them to do, voted in their own self-interest and refused the deal.

After much wailing and gnashing of teeth a new proposal was made, ring-fencing those deposits below 100,000 euros, but placing a higher burden on wealthier depositors, and being the only politically tenable solution, was accepted.

Over this period the entire banking system was shutdown to prevent a mass flight of capital, although it is now becoming clear that certain overseas branches of the Cypriot banks remained open for withdrawals and that large sums were indeed spirited out of reach of the Cypriot authorities.

 It would be very interesting to discover who those people were that made these withdrawals, I would place a small wager that it includes politicians and high ranking government officials but I’m just an old cynic.

The net result of this is that it is still unclear as to the amount of haircut these large depositors will have to take, with some of the latest estimates as high as 80%.

So with peoples’ assets being taken, businesses going bust (1 in 3 has already gone bust) and an inability to get your assets out of the country due to capital controls, it is not hard to see the potential for civil unrest.

It is clear to see from all this that life for Cypriots is tough and will get a whole lot tougher in the months ahead. But however tragic for those caught up in the mess why does it have wider implications? 

The answer to that lies in the initial plan proposed by the troika.

The big question every depositor must ask themselves is ‘How safe is my money?’ and the answer (for deposits within the euro zone) was pretty safe, because the Eurozone Banking Deposit Guarantee Scheme provided protection up to a value of 100,000 euros.

However, the initial scheme proposed by the troika included a levy on all depositors irrespective of the amount deposited. The fact it was rejected is irrelevant, it still shows that the troika think that when needs must, peoples bank deposits are fair game. This undermines the very basis of confidence in the euro-zone banking system and changes the dynamic of where to hold your investments.

The significance of the troika’s initial proposal was reinforced by the comments from the man that brokered the deal, Eurogroup chief Jeroen Dijsselbloem who said that the Cypriot package is a template for future EMU rescues, with further haircuts for “uninsured deposit holders”. Once the effects of his comments sunk in, financial markets started to react, and in spite of a later ‘clarification’ of its meaning, the damage had been done.

The bottom line in all this is that the Euro project was flawed from the start. It was sold to the citizens of Europe as a financial amalgamation that would enable all the countries that participated to grow their economies and flourish, and although that certainly was a positive by-product, the main reason was to cement relationships between the major European countries (both financially and politically) so completely, that there would never again be another European war.

Unfortunately, because it was driven by politicians with an agenda rather than people that understand financial markets, major mistakes were made, including the decision not to amalgamate all the countries debts into one, creating a single Eurobond market.

These mistakes sowed the seed for the disaster that we now face.

Because it is still politically motivated, European authorities will continue on the same course, stating categorically that something won’t happen, until of course it does, forced to make harder and more unpalatable choices, as the process grinds on to its inevitable conclusion.

It is for this reason that we are seeing currency flows out of the euro and into the US dollar, a trickle that will become a flood as the euro crisis intensifies and big money starts looking for a safe haven.

 Small money can find a home in ‘tangibles’ like housing, land, antiques or gold, outside the financial system. But big money doesn’t have that luxury, and can only be parked within the system, making the ‘least worst’ the best option, and for the foreseeable future that will be US dollars.

However, in a few years time, when the US becomes the ‘last man standing’ it will face its own financial Armageddon.

The real tragedy in all this is that as a result of the design flaws in the original concept, and the troika’s rigid adherence to a political ideology, it will likely foster the exact sentiments that the entire Euro project was designed to eradicate, with harmonious relationships and a sense of unity, replaced by distrust, anger and a move towards nationalism.

I think this is a seminal moment in the history of the Euro zone.