Escape From the Euro Zone: A Tragedy in Three Acts
What if Cyprus said no?
What if the small island-nation decided to repudiate the terms of the 10 billion-euro ($12.8 billion) bailout handed down by European leaders on Monday, bid “auf Wiedersehen” to the euro and the 16 other countries that share it, and become a free agent? What if, as U.K. member of the European Parliament Daniel Hannan wrote in the U.K.’s Telegraph this week, “Cyprus were to default, decouple, devalue -- and then prosper? What effect would a successful return to the Cyprus Pound have on the rest of the euro zone?”
Little, if any, in the short run. Cyprus accounts for less than 0.2 percent of euro-zone gross domestic product. It could be cut loose without any macroeconomic impact. European savers were unfazed by the initial rescue package’s proposed tax on insured bank deposits: Bank runs in other countries never materialized. Even the financial-market reaction to the Cypriot parliament’s March 19 rejection of that plan turned out to be a non-event. Perhaps officials in Brussels saw the response as a sign that Cyprus could be treated differently without any adverse consequences.
Over the longer term, an escape by Cyprus would signal the beginning of the end of a dream that was decades in the making: a United States of Europe. Other uncompetitive countries would see exiting as a viable option, a way of unshackling their economies from the chains of a single currency and policies more suited to, and determined by, the northern countries. (Although the Maastricht Treaty provides no mechanism for leaving the euro, a country’s refusal to comply with bailout terms would probably be a de facto deal-breaker.)
The effect on Cyprus would be just the opposite: a disaster in the short run, as Cypriot banks collapsed, taking the economy down with them. In the long run, Cyprus would become more competitive through a devalued currency rather than by a decline in wages. So who could blame Cypriots for wanting their freedom?
The rescue package agreed to early this week in Brussels is certainly better than the first go-round. In fact, it’s in line with normal resolution procedures for insolvent institutions. Cyprus Popular Bank Pcl, the country’s second-largest bank, will be liquidated, with shareholders and bondholders taking the hit. Uninsured depositors could suffer a loss of up to 40 percent. Bank of Cyprus Pcl, the largest financial institution, will be recapitalized by converting uninsured deposits to equity shares to achieve a capital ratio of 9 percent, according to a Eurogroup statement. Insured depositors at both banks will be fully protected.
So a better plan, yes, despite the haphazard execution and perilous message it sends to European bank creditors and depositors, including small savers supposedly covered by deposit insurance. It’s also unique in the context of earlier euro-zone bailouts, the cost of which was largely borne by taxpayers.
Consider, for example, the decision to spare depositors in Greek branches of Cyprus Popular, whose troubles started with the 50 percent “haircut” it was forced to take on its large portfolio of Greek government debt, a condition of that country’s bailout. Piraeus Bank SA agreed to buy Cyprus Popular’s Greek branches, with half of the financing provided by the Cyprus bailout.
The goal is to shield the Greek banking system from Cyprus’s crisis and prevent a mass deposit exodus. (Contagion would only create additional problems for German Chancellor Angela Merkel in advance of September’s parliamentary election.) Cypriot banks are to remain shut at least until today and will be subject to capital controls once they open.
Earlier this week, Dutch Finance Minister Jeroen Dijsselbloem, who serves as head of the Eurogroup, said Cyprus may serve as a model for future bailouts. Europe’s stock markets and the euro headed south, prompting Dijsselbloem to issue a terse, 37-word statement clarifying that “Cyprus is a specific case” and future adjustment programs will be “tailor-made” for each country.
So which is it? Euro-zone depositors must be wondering. Investors didn’t wait for the answer. The Euro Stoxx Banks Index (SX7E) lost almost 4 percent on March 25 and 6.8 percent so far this week.
Hannan, of the European Parliament, wonders why Cyprus doesn’t “copy Iceland, let its banks collapse, and leave their shareholders and bondholders to sustain the loss.”
That’s exactly what Cyprus is doing -- without a possible offset from currency devaluation.
Like Cyprus, Iceland’s banking system had grown to be many times the size of the nation’s economy. When short-term funding dried up during the 2008 financial crisis, Iceland nationalized the domestic units of its banks, imposing losses on foreign creditors. The krona lost 80 percent of its value versus the euro.
Today, Iceland’s economy is recovering, thanks to a weaker currency, fiscal consolidation and accommodative monetary policy. Capital controls have yet to be lifted.
It’s not clear how Cyprus will manage without the flexibility Iceland had. Cypriots may tire of waiting to see how things play out -- and opt to write a different ending for their country.
Act I of this drama dealt with the negotiations and manipulations leading up to the creation of the European monetary union. Act II was the realization. Act III, which is still being written, is certain to test the viability of “No Exit.”
(Caroline Baum, author of “Just What I Said,” is a Bloomberg View columnist. The opinions expressed are her own.)
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