The Independent Market Observer

3/20/13 – The Price for Europe Becomes Too High

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Mar 20, 2013 11:57:20 AM

and tagged Yesterday's News

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Based on some of the commentary about Cyprus, particularly in the New York Times, it would seem that the country is so small that the crisis there essentially doesn’t matter. I understand what’s behind this view, but I think it misses the point. Let’s take a closer look at why Cyprus does matter and how it could create some very unpleasant consequences in ways that perhaps aren’t immediately obvious.

Here’s the short explanation: Germany and the other major economies have decided they’re done paying any price to keep the eurozone together. A failed Cyprus bailout probably means that the country leaves the eurozone. For Greece, the rest of Europe was willing to pay almost any price to keep that from happening. Now they’re not. This is a big change, and it has implications for every country in Europe.

For the longer answer, let’s start with a recap. Cyprus’s banks are essentially insolvent—that is, their debts are greater than their assets. As such, they need a capital injection to make them solvent again. The EU had agreed to provide such an injection, but it wanted to share the pain by making participants in the banking system pay as well.

For most banking systems, there are several potential sources of that capital. Stockholders in the banks are being wiped out already, so there’s nothing there. Bonds are a very small part of Cypriot banks’ capital structures, apparently, so there wasn’t enough money there. And, since the country’s banking system is much larger than its real economy, the government simply didn’t have enough money to put the burden on Cypriot taxpayers. The only remaining source of capital that could be “bailed in” was the depositors.

Cyprus’s banking system is dominated by foreign deposits, reportedly mostly Russian. It’s suspected that many of the Russian deposits are there for purposes of tax evasion or money laundering. Along with a lack of ready alternatives, this may well have been a reason the EU pushed so hard for depositors to pay—a reluctance to bail out what it perceived as shady non-Europeans.

Now, onto the most recent developments.

As of this morning, the Cypriot legislature had unanimously rejected a toned-down version of the plan that exempted smaller deposits from the tax. By nixing the plan, even in a softened version, Cyprus left itself hanging without enough money to save its banks. The banks are closed, probably indefinitely. People can’t get their money out and may lose it. The British government is flying cash to Cyprus to pay its troops and offering them the chance to have their pay deposited in British banks rather than Cypriot ones.

Yes, Cyprus is a small country that, by itself, won’t affect the rest of Europe very much. But so was Greece. Their importance lies in their ability to affect perceptions and actions in the countries that are large enough to matter—that is, Italy and Spain.

Before, Greece had to be kept in the eurozone so that no one would even consider the possibility of leaving. Now, Cyprus may have to leave the zone, but the price the EU will pay to prevent its departure is strictly limited. With Cyprus, it’s clear that the rest of Europe may well pull out and that the average citizen—in this case, depositors—may end up on the hook.

In short, Europe appears to have prioritized not spending more money to rescue Cyprus’s banking system over keeping it in the eurozone. This is a huge change, one that has to alter the perceptions of every other country and citizen now in the zone, especially those in the weaker economies. How can this shift not affect how the average citizen—and voter—perceives the EU?

We don’t know what will happen. Germany may blink; Russia may come to the rescue; Cyprus may pass the plan after all. But whatever happens, we now know that the major economies have reached their financial and political limits, and the rules have changed. The next crisis—and there will be one—will play out without a net.

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