Dramatic days ahead in Cyprus

This column was previously published in Expansión.

The Cypriot parliament's Tuesday evening rejection of the bank levy on bank deposits, which was a key condition for financial assistance from the EU/IMF and continued European Central Bank support to the Cypriot banking system, was dangerous. At stake are nothing less than a complete meltdown of the Cypriot banking system and a possibly uncontrolled exit from the euro area.

European partners, the European Central Bank and the IMF rightly demanded the involvement of Cypriot depositors in the rescue. Without such involvement, financial assistance to Cyprus would have to be about 100 percent of Cypriot GDP, seriously undermining public debt sustainability.

Also, there is suspicion of money laundering, which lowers the inclination of European partners to absorb part of the bank losses in Cyprus. One has to add that tax rates were so low in Cyprus and the deposit rates so high, that financial investments were much more profitable than in most other euro-area countries. Term deposits yielded 4.5 percent in Cyprus in January 2013, while German savers hardly got 1 percent. Giving-back something from these gains should be seen as fair, when the Cypriot banking system has a capital shortfall of about 50 percent of GDP.

It was therefore right to demand the involvement of Cypriot depositors in the rescue. But the 15/16 March Eurogroup agreement had two major flaws. First, it should not have involved deposits below the €100,000 amount guaranteed by deposit insurance. This was not necessary and generated public anger. It potentially also undermines trust in deposit guarantee systems throughout Europe. Second, senior bondholders were not involved, even though the amount of such bonds is miniscule. The damage has been done. European policymakers were busy on 18 and 19 March blaming each other rather than recognising that all participants in the 15/16 March Eurogroup meeting are collectively responsible.

But the Cypriot parliament had the chance to correct the errors. After realising that involving small depositors was a mistake, the euro-area partners sent the message to Nicosia that the burden could be shifted to large depositors only. Cypriot lawmakers did not back them; instead, they voted down the whole idea, at least for the time being.

Without a quick and credible solution, deposits will flee Cyprus on the first day that banks open after the current bank holiday. The prospect for such a solution is limited, and therefore the risks are very high.

What’s next? European partners can hardly backtrack completely. Telling Germans that their money will be used to fully save the highly profitable deposits in Cyprus, some of which are thought to be of dirty origin, is not something the Bundestag will be happy to swallow. Also, if that was to happen, politicians in other countries may also decide on blackmail. Euro-area partners could make a small bargain, such as providing €1.3bn more – the amount of tax which was supposed to be collected from depositors below the €100,000thershold – but the scope is very limited. The Governing Council of the ECB will also face a difficult decision on whether to continue to support a banking system which is practically bankrupt, without a prospect of shoring-it up properly.

Russia may step in instead. Michalis Sarris, Cyprus's finance minister, has travelled to Moscow to seek assistance. If that should be given, Cyprus will likely have to pay a high price for it. The losses have to be absorbed by someone if depositors in Cypriot banks are to be protected in full. Russia may demand high compensation, such as control over the gas fields under the Cypriot waters. That would have geopolitical consequences as well.

The current bank holiday in Cyprus cannot be extended for too long and freezing deposits once the bank holiday is lifted is not a good option either. A new deal has to be agreed urgently. The first best option is reconsidering the issue in Cypriot parliament: the bank levy has to be passed on large deposits, while preserving deposits up to €100,000 in full. The prominent role of the Cypriot financial system is probably over anyway, so the goal should be to minimise the damage and the safeguard Cyprus’s membership of the euro area. Euro-area partners may provide a little bit more money, such as the €1.3bn mentioned above. The parliamentary decision has to be accompanied by the publication of a credible plan by euro-area partners and the Cypriot government to shore-up the island. Probably deposits will flee even in this case, but with the support from the euro-area partners and the ECB, the initial turbulence could be survived.

If a reasonable compromise is not reached, the Cypriot parliament does not reconsider, euro-area partners do not backtrack, and Russia does not step in, then we will witness a full meltdown of the financial system of Cyprus, bringing misery to its citizens. It could also endanger Cyprus’s membership of euro-area, bringing even more harm to the Cypriots. There has to be an agreement.