With Cyprus accounting for less than a quarter of 1% of eurozone GDP, it’s easy to be dismissive of the meltdown in its economy as something the eurozone can easily absorb. And the deal that was struck with the troika—ECB, EU and IMF—has been touted as a fair one since all it does it to tax rich Russian oligarchs who, in any case, were just pumping in ill-gotten gains from their mother country. And certainly the deal looks fairer than the one that sought to tax smaller deposit holders as well. According to an FT estimate, in the decade after the demise of the Soviet Union, around $300 billion found its way out of the Soviet Union after the days of “gangster capitalism”, and oligarchs found the sun-kissed Cyprus more to their liking than other tax havens. Estimates are a third of all Cypriot bank deposits are owned by Russian oligarchs. Under the deal arrived at, Cyprus banking sector—at 697% of GDP, it is positively monstrous in size—is to be trimmed down significantly. Once the deal is agreed to—in return for a 10 billion euro package from the troika, Cyprus needed to find 5.8 billion euro of its own—the funds are expected to come into Cyprus by mid-May. Since that will not prevent a run on bank deposits, presumably some bridge financing solutions for banks will have to be worked on. Capital controls are another solution once the island’s banks reopen but that is not expected to solve anything.
Investors will be making a big mistake in dismissing Cyprus as irrelevant as they did Greece some years ago—keep in mind the contagion considering Bank of Cyprus’s 2.4 billion euros of Greek debt is enough to wipe out 75% of the bank’s total capital, while Laiki’s 3.4 billion euros exposure outstrips its 3.2 billion euros of total capital. Also, the solution arrived at represents a sea change, for the worse, in the attitude of European leaders. With a banking sector that is nearly seven times as large as the economy, it is obvious a hit as big as the one just planned on larger depositors will kill Cyprus’ banking sector—in which case, where is future growth to come from and how is Cypriot debt to come down to 100% of GDP as projected? A 25-30% cut in Cyprus GDP is projected over the next two years, leaving Cyprus with unemployment levels as high as in Greece or Spain, signalling an austerity fatigue as a likely outcome and a possible Cyprus exit from the euro after a few years. The ease with which the troika attached a part of bank creditor wealth should frighten investors elsewhere in the eurozone. Even more frightening is what Moody’s called the increased risk tolerance of European authorities—that no matter how harsh their actions, investors will remain invested and countries will not exit the eurozone. That’s a big gamble.