The firestorm of criticism for a European Union-mandated bank tax has left Cyprus scrambling to rescue the bailout.
Cyprus has a population of less than a million. And it’s the third smallest economy in the eurozone, bigger only than Malta and Estonia.
But the country’s banks need rescuing and in return for European Union help, its heavily-indebted government is facing demands to impose a tax on bank customers. The result: After months of relative calm, the European debt crisis is once again generating headlines.
So what’s so important about this bailout?
1. Bailout or bankruptcy: Without financial support from somewhere, Cyprus will be unable to meet its financial commitments. Why? The country’s outsized banks have been crippled by losses on Greek debt, and it can’t afford to bail them out on its own.
The country’s debt-to-GDP ratio, currently around 87%, is on course to soar to an unsustainable 140% without a bailout. A messy default could lead to exit from the eurozone and revive fears about the viability of the currency area.
“A disorderly bankruptcy would have forced us to leave the euro and forced a devaluation,” Cyprus President Nicos Anastasiades said Sunday.
2. First-of-its-kind bank tax: By opting for the first time in a sovereign bailout to impose losses on bank depositors, the European Union has set a dangerous precedent that will anger savers and trouble investors. The tax has compromised a fundamental principle that professional investors — shareholders and bondholders — not depositors should feel the pain of a bank failure.
Any bank run at this point outside Cyprus seems unlikely. But the fact that a line has been crossed could make it harder for policymakers to prevent similar panic from spreading in the future should another eurozone state find itself needing a bailout.
3. European credibility: Imposition of the bank deposit levy risks undermining Europe’s credibility in managing debt and bank crises.
Assurances that the measure is unique to Cyprus may ring hollow. Similar pledges were made when private holders of Greek government bonds were forced to accept losses as part of a bailout.
It could lead to a flight of capital to safer destinations within the eurozone and beyond. In turn, that could undo some of the improved sentiment toward peripheral eurozone countries that has been built on the back of painful economic restructuring and pledges of support from the European Central Bank.
4. More pressure on eurozone banks: Bank shares tumbled across Europe on Monday. Investors in eurozone banks, particularly in weaker countries, may demand a higher risk premium to hold those assets, pushing up banks’ cost of funding.
That will add pressure to revenue and earnings, and some banks could lose access to wholesale funding altogether, noted analysts at Germany’s Berenberg Bank.
And all this comes at a time when the region’s banks are still struggling to repair their balance sheets and lending to weaker eurozone states remains throttled, reducing the chances for a return to growth. The International Monetary Fund said just last week that Europe’s banks remain fragile.
5. Losses for Russia: Cyprus banking assets are about eight times the size of the economy, and foreign investors hold just under half of all deposits, which total around €70 billion. Russian companies and individuals have heavy exposure to banks in Cyprus.
Moody’s reckons Russian corporate deposits are worth about $19 billion and any default could affect the servicing of bank debt in Russia.
Russian officials had been talking about extending the maturity of an existing €2.5 billion loan to Cyprus, and possibly reducing the interest rate. On Monday they said they were reconsidering that plan after the EU failed to include them in bailout discussions.