Cyprus: the latest casualty of the Eurozone crisis

By Kara Odum ’15Economics Columnist

The Eurozone crisis has been dragging on for nearly three years now, with periods of rioting, public unrest, and fierce negotiations between financially unstable countries and the troika, made up of the European Central Bank, the European Commission, and the International Monetary Fund. While most countries have been hit with recessions following the 2008 financial collapse, some have fared better. With multiple countries vying for the Financial Failure Medal, Cyprus is the winner of the month.

Cyprus joined the EU in 2004 for the political protection the EU offered, not for economic reasons. Low corporate tax rates and double taxation treaties, which exempt companies from taxes both in Cyprus and in their home companies, have drawn foreign business to Cyprus for several decades. This is partly why so much money from Russian businesses ended up in Cypriot banks.

In 2008, Demetris Christofias, a communist, was elected president based on a political platform of reunifying the island and solving political problems with Turkey. Throughout his time in office, the Cypriot government took a fiscally healthy country and overspent on unproductive projects. This resulted in international investors losing confidence in Cyprus because of its new fiscal policies, and Cyprus ultimately lost access to capital markets in May 2011. Making matters worse, an explosion destroyed a power station that produced half of the island’s power. The country was thrown into recession.

At this time, the European Banking Authority reviewed two of the largest Cypriot banks via a stress test. While the banks passed, they needed some extra money to get them through the recession. To avoid asking the troika for a small loan package, the Russian government gave Cyprus a loan of 2.5 billion euros.

On Oct. 27, 2011, the real problems started. The EU council decided to wipe out 80 percent of the value of Greek debt held by the private sector, which meant a 5 billion euro writedown for Cypriot banks. In conjunction with a capital shortage in the euro area, the EU also mandated that banks hold more capital to hedge against risk. Cyprus couldn’t come up with the additional capital needed because the government was trying to distance themselves from the banks, otherwise the government could have issued public debt to raise money for the banks.

In June 2012, Cyprus bonds were downgraded to below investment grade; the government debt was not eligible for collateral. The troika had waved this restriction in Greece and Ireland but did not for Cyprus because the banks needed to go through structural adjustments to remain solvent. Cyprus asked the troika for assistance and began implementing programs such as reductions in pension benefits, wages, and salaries of the public sector as well as privatizing government owned corporations, which had been standard practice throughout the EU when a country was asking for financial assistance.

On March 1, 2013, the new president Nicos Anastasiades came to office hoping to get the country’s finances straightened out by completing the adjustment program. However, in March, Anastasiades was forced with either haircutting deposits or cutting off liquidity to the banks. The troika had opted for a bail-in, which would have levied a tax on all deposits in Cypriot banks but was later changed to leave out insured deposits of under 100,000 euros.

Angela Merkel, the current Chancellor of Germany, is up for re-election in Sept. 2013, which has sparked some speculation that the new strategy of bail-ins was politically motivated. There is some truth to that statement because forcing losses on deposit holders has not been a part of previous bailout packages to countries like Greece, Ireland, or Iceland. Also, people in Germany have been labeling any assistance to Cyprus as an attempt to bail out Russian oligarchs, which is not a popular political move.

This strategy will hurt public confidence in the banks and hinder future economic recovery. Furthermore, Cyprus’ trouble and the following EU response have set a new precedent that puts the rest of Europe in danger of losing even more public confidence. Bank deposits are typically very safe and insured to a certain amount, but with the bail-in, people might think twice before trusting a bank with their money. This alone can stunt Europe’s economic growth even more because without money for banks to lend, people can’t get loans for houses or businesses. It will be interesting to see how Europe responds to this new development as Spain, Italy, and Greece remain in financial jeopardy.