The package approved last night for salvaging Cyprus is most likely to plunge it into utter disarray. The second largest bank will be winded up while the main one is due to undergo a drastic restructuring. Money coming from Europe, a mere €10 billion, seems largely insufficient to fill the huge gap of a devastated financial sector that stood as the main driver for the economy in the past.
The heavy toll to be paid by senior bond holders plus depositors on top of €100.000 will push investors to fly as far as they can from the very moment capital controls are eased. A run on deposits from domestic savers is also to be feared. The stiff measures implemented to avoid a banking discomfiture will only spark serious doubts on the merits to hoard your savings in a credit institution. As the country turns into a cash settlement area, it will embark on a one-way ticket to sheer misery. Economic activity is bound to come close to a complete halt as lack of liquidity wreaks havoc on it.
Government and local politicians are to blame for trying to preserve unscathed a financial system that seemed largely in bad shape long ago. But surely the European Central Bank should have swiftly reacted well before the current crisis unfolded. Euro zone partners have also played a dubious role by rubber stamping the original Cyprus prime minister’s attempt to raid on modest depositors’ savings, thus triggering a full-fledged financial panic in the island with spill-over effects on confidence in other vulnerable countries.
Cyprus banking foreign liabilities amount to three quarters of a staggering and untenable external debt equivalent to nearly 5 times the national GDP. Most of it is made up of deposits, securities and loans representing a marginal fringe. In January 2013 outstanding loans amounting to €72 billion were overwhelmingly supported by €68 billion deposits, only €26 billion being held by domestic households. Thus, even if the plan to raise €5.8 billion for matching EU demands is finally endorsed by international lenders, the risk the financial system might implode runs high. So long stiff capital control measures are in place the economy will enter into a free-fall. But as soon as they are lifted, the run on accounts might likely lead to a banking collapse.
Cyprus prime minister has played with fire and his country is bound to be burnt.
The only way to escape from a doomsday scenario would be to downsize the banking system in an orderly way. But such a vast scale restructuring needs a lot of funding and a rather long period to subdue the adjustment shock. Neither of them will be at hand for a government that has lost its credibility over the last days. Fancy ideas like ransacking pension funds, readily shrugged off by Euro partners, have increased mistrust and led to tougher conditions than warranted. Help from the EU will only step in should the situation spin off out of control. As things stand now, this dire prospect might be closer than expected.