Cyprus

Big news out of Cyprus this weekend. Depositors at Cypriot banks had 10% of their deposits taken away from them overnight.

Backstory: Cyprus is a large island in the eastern Mediterranean. Over half of it is a Greek-speaking independent country called Cyprus. Cyprus is the third smallest country in the European Union, and the third smallest in the Eurozone. During the hottest part of the Eurozone crisis of the last few years, Cyprus was quiet. But, it’s moved to the top of the problem list over the last year.

The issue with Cyprus is an unstable financial sector. Many Russian oligarchs (who can get their wealth out of Russia) park it in banks in sunny Cyprus. A tax haven with a lot of cash inflows is not a recipe for good financial decisions. And where did Greek-speaking Cypriot bankers prefer to invest their deposits? Nearby, in economic basket-case Greece!*

One of the things macroeconomists worry about with financial crises is that they are contagious. In the case of Greece and Cyprus, last spring, holders of Greek government bonds were forced to accept a write-down of the maturity value of their outstanding bonds in exchange for new loans to the government. Basically, the story for those investors was: the government you invested in put its own economy in the toilet, so your bonds aren’t worth much now, and if the new loans help raise the economy out of the toilet, you shouldn’t be able to benefit from that. This is called a “haircut”. The thing is, one of the big losers in this particular haircut was Cypriot banks.

So, for a year, Cyprus has been teetering, with the government supporting its banks with emergency loans — often financed by loans from the Russian government. It’s been clear for a while that Cyprus needs a more formal bailout from the EU.

Except the EU is dominated by financially sound Germany, which is getting tired of this. It doesn’t help that bailing out Cyprus amounts to bailing out rich Russian individuals who probably got their money from graft in Russia, supported in part by cash flows from high natural gas prices paid by  … the Germans!

This time they’ve come up with a new haircut. All Cypriot bank depositors learned, after the close of business on Friday evening, that they will lose 10% of their deposits on large accounts, and 7% of small accounts. The Eurozone imposed this measure to fund about 1/3 of a $17B rescue plan that will help keep Cyprus in the Eurozone.

Of course, there were runs on ATMs on Friday. It isn’t clear if the banks will be able reopen successfully on Monday. And the legislature of Cyprus has yet to approve the move. But, how can they turn it down when the bailout package is conditional on it? Since they’re the ones who have to enforce it, you’ve got to think that they implicitly agreed to go along with this before it became official, and that they just have to make that approval explicit.

Here’s a negative view of this policy move. Here is a more positive one. Both agree we are in uncharted waters.

Do note that it is good when policymakers try new things, especially if the old way didn’t work. On the other hand, surprises like this are a big deal: remember how the American economy responded in 2008 to the government’s decision not to bail out Lehmann Brothers, as they had other failing financial institutions.

* Cyprus has not been helped by the destruction from one of the largest accidental explosions in history.