Good News for Cyprus?

Though Cyprus’s predicament is nothing out of the ordinary for a member of the troubled eurozone, recent developments in the small nation have nonetheless managed to take economists by surprise.

Cyprus was originally offered a ten billion euro bailout to stave off bankruptcy, but the money came with a catch: it could only be secured if the nation could raise 5.8 billion euros itself. “The fact is,” says Arvind Krishnamurthy, a professor of finance at the Kellogg School, “there are banks all over Europe [that] are undercapitalized because they’ve lost more money than they have liabilities.” Yet Cyprus alone has been asked to pay up.

How? The original plan was to tax investors—a historic first. Specifically, Cyprus was called on to extract a one-time levy of about ten percent on uninsured deposits and—most shockingly of all—6.75 percent on insured deposits, those under 100,000 euros. This brought to light some rather uncomfortable questions about just who was insuring these deposits, says Krishnamurthy, as there is no European equivalent to the U.S.'s Federal Deposit Insurance Corporation. If this is what the European Central Bank asks of Cyprus, does this mean that small deposits in Italy and Spain are also not protected? Taxing insured deposits, Krishnamurthy feels, would have been a perfect recipe for a bank run.

Needless to say, the original deal was not a hit with most Cypriots either, and Cyprus’s parliament put the kibosh on it. But late last night came word of a second deal—just two days before the European Central Brank’s spigot of emergency assistance was set to run dry.

In the new deal, the nation’s second largest bank, Laiki, will be closed, and all of its uninsured deposits transferred to a “bad bank,” where losses could be quite severe. Uninsured deposits at the Bank of Cyprus are also under threat. This comes as terrible news for the many Russians and other foreign nationals who are large depositors in Cyprus’s banks. However, the deal does leave smaller depositors—most ordinary Cypriots, that is—unscathed.

So is Cyprus in the clear? Cyprus will probably lose its most lucrative industry, Krishnamurthy tells me. In recent times Cyprus has greatly benefited from large sums of money coming in and out of the country; without it, there will be job losses. Indeed, Krishnamurthy admits, it’s not completely clear whether this alternative is any better than leaving the eurozone. Upon leaving, currency would depreciate, let’s say by 25 percent. This would increase the costs of imports by that same 25 percent, says Krishnamurthy, “but your local prices—say the price of a haircut—are still exactly the same.”

The real winner here just might be the rest of the eurozone. “Cyprus leaving would raise lots of questions,” cautions Krishnamurthy. Had this happened, he believes, the onus would have been on the eurozone to explain why. Last summer Mario Draghi, the president of the European Central Bank, calmed the markets by vowing to do whatever it took to preserve the eurozone. But of course a Cyprus exit would be a “statement that you haven’t done whatever it takes” and that some nations would be saved while others would not. Last night’s deal averts a crisis of faith in the euro—at least for now.

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