Cyprus accounts for only about 0.2 percent of the Eurozone’s GDP, with a national output that is roughly that of Vermont and a population about the same size of Philadelphia. So why is the proposed bailout of the island nation’s banking system – which will be partly self-funded by taxing the bank accounts of its citizens and businesses – arousing such outrage?
It isn’t just the principle of the thing. After all, those likely to be outraged at the idea of a direct levy on Cypriot bank accounts by the government are likely to be the same folks whose blood pressure soars when contemplating the kind of irresponsible fiscal policy and other behavior by Cyprus that put the banking system in jeopardy in the first place, and made a bailout necessary. And anyway, that would be a purely Cypriot affair.
Furthermore, to the extent that other countries are directly involved, that country is Russia, not other Eurozone nations, the United States or China. For more than a decade, Cyprus has been a favorite place for all kinds of Russian business interests – legitimate and otherwise – to park large quantities of cash, safely out of sight and reach of corrupt Russian officials. Moody’s has calculated that Russians have $19 billion of deposits in Cypriot banks and that Russian banks have even greater exposure to the country, with $12 billion of deposits and $40 billion in loans, mostly to local companies established by Russians.
It is that Russian factor that, in the eyes of many, has made the “bail in” proposal necessary in the eyes of other Eurozone nations. “If you are a German or Dutch taxpayer, it’s one thing to bail out Spain, where maybe you have a summer house that you have financed by taking out a mortgage with a Spanish bank,” says Marty Leclerc, managing partner of Barrack Yard Investors in Bryn Mawr, Pennsylvania. It’s another matter, he argues, to be asked to finance a bailout of Cyprus banking institutions “that would be seen at home as a bailout of Russian gangsters.”
Indeed, the impact of the Cypriot “bail in”, as proposed, would hurt Russia disproportionately. That’s true not only because of the immediate tax on deposits, but because to the extent investors respond by fleeing the country, Cyprus might well decide to freeze capital outflows. That could take a serious toll on Russian banks expecting interest income on those loans. No wonder, then, that Russian President Vladimir Putin has dubbed the plan “unjust, unprofessional and dangerous.”
But even the prospect of losses on the part of Russian banks isn’t enough to explain the waves of jitters that have swept through global markets since details of the ‘bail-in’ were unveiled a few days ago. True, part of it is simply due to the fact that stocks in both the United States and Europe have done relatively well so far this year, and probably were poised for some kind of retreat. The events in Cyprus served as the catalyst for a selloff.
Still, there are some serious, albeit longer-term reasons why investors may want to worry about what Cyprus means. Looked at in isolation, this is a small bailout that probably won’t rock the boat, much less weigh on Eurozone budgets, especially when set beside what has been happening in Greece, Spain and Italy. But it does raise questions about what might happen down the road in some of those other nations: the ever-present fear of contagion.
Consider, for a moment, that you are a Spaniard living in Toledo or Avila. Unemployment stands north of 25 percent; your children, in their early 20s, have less than a 50 percent chance of finding work. Your life savings are in an unstable financial institution, reliant on the goodwill of Eurozone institutions and policymakers for survival.
What would you do, watching the news about the Cypriot plan, if you thought that just possibly, the Germans and others who already have insisted on tough austerity measures might demand a similar tax on your savings as the price of bailing out and stabilizing your bank, when you feel you may need every penny of those savings to stay afloat? That’s right, all the ingredients would be in place for a run on Spain’s banks – however irrational and unfounded those fears may be in practice.
That’s the short term scenario, and it is made slightly more plausible by the question that lies at the heart of the longer-term anxiety: the lack of confidence and trust in those European policymakers. Eurozone institutions might tell Spaniards, hands on hearts, that such a measure would never be dreamt of in connection with Spain. They may even be sincere in that. But will the Spanish population believe they are sincere? That is one of the concerns that Paul Christopher, chief international strategist at Wells Fargo Advisors identifies: that there is an internal argument within Europe about who should foot the bill for past excesses.
To the extent to which northern nations – the traditional “have” nations within the Eurozone – insist that members on the periphery foot the bill for excessive bank lending or sovereign debt, a vast political rift could emerge dividing the core from the periphery. For many of these countries on the periphery – Spain, Portugal, Greece, Ireland – prosperity is still only a generation old, with those over the age of 50 vividly recalling the days of struggling to save to acquire a motorcycle, much less a car or a house. Being forced back into that era may make European union politically impossible.
That has big ramifications for investors worldwide, as does another issue that Christopher raises: the ability of Europe’s leaders to think past solving these recurring country-specific crises and devising a solution to the region’s underlying woes. That will be difficult and full of controversy, requiring politicians in every nation to make deeply unpopular decisions. “European leaders appear to have grown complacent as the (European Central Bank) has stepped up as the lender of last resort,” Christopher wrote in a note to clients this week.
For his part, Christopher believes that the ECB’s commitment to keep the European experiment on track by buying short-term debt of the region’s troubled governments contributes to confidence among global investors. We may not see the same magnitude of selloff in response to European headlines that we witnessed in 2011 and 2012, but the long-term challenge can’t be avoided, and it’s not one that European leaders can continue to postpone. Ultimately, trust needs to be returned to the region’s institutions, and that requires convincing steps being taken to a lasting solution, not just an ad hoc crisis-by-crisis response.
Cyprus is a timely reminder that there are plenty of unresolved issues outside the borders of the United States that, in this global age, have the potential to rattle financial markets.