Economic News & Analysis—March 18, 2013

Cyprus—the last straw?

By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist

The basic bargain

The Eurogroup, a body consisting of the 17 finance ministers from eurozone countries, announced on Saturday that Cyprus will receive a 10-billion-euro bailout if the Cypriot government passes a number of measures. Part of the proposal includes depositors in Cyprus’ banks to be taxed on their deposits: 6.75% on deposits of 100,000 euros or less and 9.9% on balances above that amount. The goal is for the total tax on deposits to amount to 5.8 billion euros. To ensure compliance with the tax, all accounts are frozen until banks reopen on Tuesday after a Monday holiday, and the tax will be automatically deducted from accounts before the banks reopen. Depositors will receive equity in their banks to at least partially offset the confiscation of their money.

To effect a more equitable deal would have required the Central Bank of Cyprus, a member of the euro system of central banks, to take losses on loans it was making to the few Cypriot banks it was propping up. That could have created some additional political issues with the European Central Bank (ECB) considering the ECB is not the lender of last resort to governments, but the bank losses would have been due to an agreement to deal with the Cypriot government’s finances. In other words, the problem became almost intractable because policymakers were trying to deal with both bank problems and public-sector finance problems as part of one package.

A solution that’s worse than the problem

While temporarily fixing one problem of teetering public-sector finances in Cyprus, the proposal could trigger bank runs in other eurozone countries with shaky public-sector finances, leading to a credit crunch for households and small businesses that depend on bank lending. It is unprecedented to impose losses on depositors of banks, especially smaller depositors that are supposed to be protected by deposit insurance. In my opinion, the losses should have been fully imposed on equity holders, then debt holders, and then large account holders. Only as a last resort should any losses have been imposed on smaller account holders.

In my view, this bailout plan is a flawed deal and seems like a sop to appease foreign depositors in Cypriot banks, who are the main holders of large deposits. Cyprus had become a favorite tax haven and money-laundering port after it joined the eurozone. I believe this bailout deal undermines the progress that has been made to date in keeping the eurozone together.

Some have argued that the Cyprus deal is unique and not a precedent for how other government finance problems will be dealt with. The problem with that argument is that every crisis is somehow unique. This is a small-scale experiment. Each time a new treatment is experimented with, as was done with private-sector creditors in Greece and now with Cypriot depositors, similar treatments are applied in the future. I expect Italian and Spanish bank depositors will see this as a warning, and we’ll likely see more deposits flow into German banks.

Another major problem with the Cyprus deal is that it may undermine Cyprus law and independence. The Cypriot constitution is supposed to protect against the uncompensated taking of property (Article 23) and the application of taxes to retroactive activity (Article 24). The fact that the decision to impose the tax on deposits was made and would be applied to balances that were already in the accounts seems to contravene this provision. Whether or not the bailout goes through, this likely sends a clear message to the citizens of eurozone countries that protecting the finances of the eurozone institutions is more important than the integrity of national laws.

I am currently negative on the eurozone and fear this little island could be the catalyst for many problems. As such, I’d be underweighting the eurozone now. I don’t think a decline in eurozone stocks creates a good buying opportunity because there are likely more problems to come.

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