What's behind the bailout crisis in Cyprus?

Cyprus is the latest victim of the eurocrisis, in which a combination of highly indebted banks and unsustainable sovereign debts brought several members of the eurozone to the brink of bankruptcy. But the Cypriot crisis entails unique features that have shaped how it has developed – and the impact it is having on the rest of Europe and the eurozone.

How did Cyprus come to need a bailout?

“The Cypriot banking sector is overblown and under-regulated,” says Michael Wohlgemuth, an economist and director of the Berlin-based think-tank Open Europe. “This is essentially what made the bailout necessary.”

According to Deutsche Bank Research, the volume of Cypriot banks is seven times bigger than the country’s GDP – in Europe, only Luxembourg and Malta have a higher ratio. High interest rates and easy access have attracted a lot of foreign capital to Cyprus, and the country has developed a reputation for being a tax haven and even a money-laundering location.

But the Cypriot banks’ high exposure to bad Greek debt meant that when Greece negotiated a debt write-off – the so-called "haircut" – for its struggling financial institutes in February 2012, Cyprus took a severe blow.

Downgraded by the big rating agencies, Cypriot banks were cut off from the international financial markets and only kept alive through infusions from the European Central Bank (ECB). But the central bankers in Frankfurt threatened to withhold even these emergency funds unless Cyprus agreed to a deal, so Nicosia budged, accepting to raise around 5.8 billion euros to qualify for a 10 billion euro bailout.

How is this bailout different from previous ones?

Fearing a domino effect on other member states and indeed the global economy, the eurozone has so far preferred to pay substantial amounts of financial aid than let any of its ailing members go bankrupt and leave the common currency. But Cyprus is a special case in a number of ways.

First of all, the Cypriot economy is arguably too small to be relevant to the health of the entire eurozone.

It was this argument of systemic relevance – and the threat of contagion – that European leaders used to convince their national parliaments that Greece, Portugal, and Ireland needed to be kept solvent and within the common currency. A special tool, the European Stability Mechanism, was even created to signal to the international financial markets that the eurozone would do everything to rescue its members. But the small island in the Mediterranean has little negotiating power.

Secondly, there is the Cypriot business model.

Even though the government in Nicosia vehemently denies accusations of money-laundering, Cypriot banks have attracted large amounts of capital from sources seen as dubious by the rest of the eurozone. Around 20 billion of the 68 billion euros deposited in Cypriot banks are thought to be owned by Russians.

Germany, Austria, Finland, and the Netherlands made it quite clear that they were not willing to use their taxpayers’ money to bail out Russian millionaires. A different bailout model had to be found.

So, for the first time in the eurocrisis, private account holders in the receiving country are forced to co-finance the bailout: to “bail in,” effectively having part of their capital confiscated.  

“This is a major shift back to the basic principle of liability,” says Professor Wohlgemuth. “It means that if you invest in a high interest rate environment you accept a higher risk, rather than asking taxpayers from other countries to cover your losses.”

The plan has proven enormously unpopular in Cyprus. But while no European institution nor the Cypriot government has been willing to claim responsibility for the idea of targeting bank deposits, they have agreed to its implementation.

What now for Cyprus?

The impact of the bailout deal on Cypriot society is enormous.

Everyone with an account in Cyprus holding more than 100,000 euros – the maximum amount guaranteed under EU law – will have around 40 percent of their deposits turned into bank shares. It is impossible to say what these shares will be worth in the future, if anything. Plans to include account holders with less than 100,000 euros in the bail-in were dropped after furious protests and lack of parliamentary support in Nicosia.

Cyprus’ second largest bank, Laiki Bank, is going to be closed. Some 4.2 billion euros worth of accounts that contain over 100,000 euros will be placed in a "bad bank," thereby isolating them from more stable assets. The other accounts will be transferred to the Bank of Cyprus, the country’s largest bank, which will undergo a restructuring process.

When banks opened again in Cyprus Thursday after a two-week closure, customers faced not only armed guards and police at the branches, but also severe restrictions on the movement of capital. Daily withdrawals are limited to 300 euros, no checks can be cashed, credit card transactions abroad are limited to 5,000 euros per month. Businesses can carry out transactions of up to 5,000 euros per day only, and any commercial transaction over 5,000 euros needs to be reviewed by specially formed committees.

The Cypriot ministry of finance insisted that the capital control measures would be a matter of days, perhaps weeks. Analysts are not convinced.

“Such measures are extremely difficult to reverse,” says Guntram Wolff, vice-director of the Brussels-based think tank Bruegel. “Iceland introduced them after their banking crisis – five years later they are still in place.”

But even if capital can flow freely again in Cyprus, the future looks bleak. Experts agree that the economy will be going into a recession that could last years.

“Their business model is shattered,” says Volker Treier of the German Chamber of Commerce. “They need to focus on the tourism industry now and hope that they can develop those natural gas fields off their coast.”

What are the consequences for the rest of the eurozone?

This question is fiercely debated in European capitals now: Is the Cyprus bailout a one-off, or a model for the future?

Jeroen Dijsselbloem, the Dutch finance minister and recently-appointed head of the Eurogroup, caused a shock in the financial world when he told Reuters that from now on account holders and investors should prepare to carry some of the burden in bailouts. The statement sent shares around the world tumbling and drew strong criticism from several of Mr. Dijsselbloem’s European colleagues.

The Cypriot bailout raised a second question across Europe: If the Cyprus business model is not viable any more, what about other places with a similar economy? Luxembourg’s foreign minister, Jean Asselborn, lashed out against Germany, which had been particularly critical of Cyprus’ oversized banking sector. “Germany does not have the right to dictate the business model for other EU countries,” Mr. Asselborn said, rather undiplomatically.

In Berlin, they are trying to play the debate down. Cyprus was a special case, insisted Germany’s finance minister, Wolfgang Schäuble.

This assertion might be tested sooner than expected. Apparently Slovenia’s banking sector is in very bad shape. The country could be the next to apply for a bailout.