How the European Union killed Cyprus in one day

Commentary: Bailout for Cyprus could become euro zone’s problem

ReutersAnti-bailout protesters hold a banner and a Cypriot flag in capital city Nicosia.

SYDNEY (MarketWatch) — With no other source of aid available and the European Central Bank threatening withdrawal of emergency funding, Cyprus faced default and rapid economic collapse.

After balking at the original, controversial bailout provision that required ordinary depositors to pay a “tax” or “solidarity levy” on Cypriot bank deposits, Cyprus struck an amended deal early Monday with the European Central Bank, the European Commission and the International Monetary Fund — collectively known as the troika.

The new measure staves off the risk of immediate collapse and the threat of Cyprus’s having to abandon the euro. But the plan doesn’t solve Cyprus’s problem. Or the euro zone’s.

The Cypriot bank-restructuring plan may not raise sufficient funds. It will encourage deposit flight, compounding the problems. As with Greece, there is a risk that Cyprus will need additional assistance, entailing further write-offs of depositors’ funds. And, as with Greece, privatization proceeds and the revenue from increased taxes may not reach targeted levels.

In 147 banking crises since 1970 tracked by the IMF, no depositors, irrespective of the amounts held and the banks with whom the deposits were placed, suffered losses.

The proposed restructuring also destroys the Cypriot banking industry.

The transfer of losses to depositors and imposition of capital controls make it highly likely that activity will shift to other locations. Given that banking is a major economic activity, this reduces Cyprus’s capacity to pay back its creditors.

Russian businesses are unlikely to continue to patronize Cyrus. Press reports quoted one Russian businessman’s wry observation that the EU had killed Cyprus in one day: “When the Russians leave, who is going to stay at the Four Seasons for $500 a night? Angela Merkel?”

Slide show: Countries most exposed to their banks.

Greater risk to euro zone

Irrespective of the fate of Cyprus, the solution adopted for the country will exacerbate the European debt crisis.

First, the transfer of losses to depositors creates a dangerous precedent. In 147 banking crises since 1970 tracked by the IMF, no depositors, irrespective of the amounts held and the banks with whom the deposits were placed, suffered losses.

Depositors in weak banks in weak countries now may consider the risk of loss or confiscation. This may trigger capital flight from banks in Greece, Portugal, Ireland, Italy and Spain.

If depositors withdraw funds in significant size and capital flight accelerates, then the ECB, national central banks and governments will have to intervene, funding affected banks and potentially restricting withdrawals and electronic fund transfers and imposing cross-border capital controls.