Cyprus: new fault lines in the Eurozone

What to make of the Cyprus rescue deal announced this morning? Is it necessary? Absolutely: the Cypriot banking system is insolvent, and has been ever since the Greek rescue deal last year, if not before. Is it fair? Probably not. Knowing how weak the Cypriots’ bargaining position was, the troika (EU, ECB and IMF) has played hardball with one of the EU’s smallest member countries, which makes it certain that for every irate mobster or money launderer who loses a chunk of their capital, there will also be many hard luck cases.

The deal administers rough and ready treatment to bank depositors in the country’s two largest banks, while preserving – belatedly, and at the second attempt – the general principle that depositors with less than $100,000 euros are still protected from loss by state guarantee. (Important to note that while the EU has enshrined this principle as a political objective, the guarantees are only as good as the individual state that provides them. Cross-border deposit insurance, under which the EU would collectively guarantee bank deposits in all member states, is necessary if the banking union which the EU is trying to edge towards is ever to become a reality, but it remains so electorally toxic that it won’t be introduced any time soon).

Will the Cyprus deal work? In the short run, yes – hence the relief with which it has been greeted by financial markets today. What we don’t know yet is how the longer term consequences will play out. Two notable features of the Cyprus deal are particularly important. The first is that senior bondholders are being forced to take a haircut as part of the deal, something that has not so far happened in any of the four previous Eurozone bailout deals. That potentially sets a precedent for the future, just as the recent Dutch bank rescue did for junior bondholders.

The second is that, even after this bailout deal, the Cyprus authorities are surely going to have to continue to impose capital controls in order to prevent a ruinous flight of money out of the country when the banks finally reopen. That in turn casts an ominous new shadow over the future of the Eurozone, as a fundamental founding principle behind the creation of the EU is to create the free flow of labour and capital across borders.

Any country which, like Cyprus, now has to impose capital controls to preserve what is left of its shrinking banking system is effectively operating with a different, lesser class of euro than all the other member states. The biggest unknown of all is whether depositors in other southern European countries will decide to take heed of what has happened in Cyprus and once more start to move their money out of their domestic banks for fear of eventually succumbing to a similar outcome.

Having vowed to do “whatever is necessary” to preserve the euro, the ECB has presumably calculated that the risk of such capital flight from Greece and Spain, which was starting to accelerate in the months before Mr Draghi’s effective verbal intervention last summer, will be manageable. Time will tell.

The Cyprus deal will rightly be welcomed by financial markets as preferable to a total messy collapse, but the longer term implications are the one that matter most. With most of Europe still mired in recession, and as Mohammed El-Erian of Pimco noted this morning, bailout fatigue reaching dangerous levels, the clock continues to tick ominously for the single currency.