The Domino Effect and Why Cyprus Matters for U.S. Investors – Published in Noozhawk on Monday, March 24, 2013

The latest in a long line of problem countries in the European Union, Cyprus has dominated headlines for the past week, with a banking system teetering on the edge of collapse.

A tiny island country of 1.1 million residents and a gross-domestic product that represents just 0.2 percent of the total GDP for the EU, Cyprus may seem to be too small to matter, especially to American investors. However, as a member of the EU, Cyprus is a link in a long and very important chain and represents a significant threat to U.S. and global financial markets.

Cypriot banks have been closed since March 16, having exhausted all liquidity theEuropean Central Bank was willing to provide. An offer of a €10 billion (about $13 billion) bailout was conditional, with a requirement that Cyprus raise €5.8 billion to qualify. The Cypriot Parliament’s March 19 vote on the bailout — including a tax on depositors of 9.9 percent for those with deposits above €100,000 and 6.75 percent on those with deposits of €100,000 or less — failed, without a single yes vote. Cypriot banks, which had been scheduled to open Thursday, remained closed as Cyprus’s finance minister traveled to Russia to beg for money. After three days of negotiations, he returned empty-handed, and the parliament returned to discussions, trying to find a viable solution to the crisis.

Cypriot banks have €68 billion in deposits, with about €38 billion of this coming from non-citizens. Cyprus has long been a destination for funds from unscrupulous and illegal activities, with lax banking regulations designed to attract capital from outside the country. Cypriot banks, in turn, have taken these deposits and made risky loans and investments — especially in troubled Greece — that have now placed their entire banking system at edge of collapse. Wealthy Russians are believed to have billions of euros deposited with Cypriot banks, which is why the Cypriot finance minister believed Russia would provide a loan to secure the bailout.

The Cypriot parliament was considering a number of options with regard to the country’s two largest banks. The latest negotiations seem to support protecting all deposits for those with up to €100,000 in these two banks, but deposits above €100,000 could see between 30 percent and 50 percent of their funds converted into stock in the new, presumably stronger and better capitalized banks. The parliament is also considering a good bank/bad bank method, through which those with deposits above €100,000 would have to wait for the proceeds of the sale of assets from the “bad bank” to get some of their money back. They could receive anywhere from 50 percent to 70 percent of their money, according to those familiar with the numbers and the quality of the assets in this scenario. Neither of these options will be appealing to depositors, who will basically see their checking account balances either become a stock investment, or what amounts to a bond investment or time deposit, with an unknown maturity date.

Cypriot banks are scheduled to reopen Tuesday, a day after the EU’s Monday deadline for Cyprus to present its plan for raising the €5.8 billion required to receive the bailout. Although depositors have been standing in line for the past week at ATMs to withdraw as much as possible, when banks reopen, there most likely will be tight capital controls restricting withdrawals from the two troubled banks — Bank of Cyprus and Cyprus Popular Bank, also known as Laiki — and probably at all banks throughout the country, as depositors will no doubt scramble to withdraw their funds. If the parliament cannot agree on a plan to raise the required €5.8 billion, these two banks probably will never reopen, at least in their current forms.

For depositors, and especially for those with more than €100,000 in these two banks, the choice comes down to a lesser of two evils: accept a huge tax on your deposits or suffer through a complete collapse of the Cypriot banking system with little chance of getting much of anything back. With this stated, there really is no choice on the part of the depositors, as the choice is out of their hands and in the hands of the Cypriot parliament.

I believe Cyprus will vote for a plan to raise the required funds for the bailout. Confidence in its banking system has been shaken, however, and it is unlikely that it will return. Regardless of the outcome, Cyprus will no longer be seen as an international banking destination for wealthy foreigners, and this outcome will have serious implications for the long-term health of its banking system.

Beyond Cyprus, there are many other countries within the EU that have similar banking system and sovereign debt issues that will need bailouts to remain in the EU and to continue using the euro as their currency. Slovenia is the next domino to fall, with a €1 billion note coming due June 6 that must be refinanced or it will be in default as a country. In all, Slovenia will need about €3 billion in refinancings and new financing this year to stay afloat and avoid a sovereign debt default.

There are 27 countries in the EU, and a large number of these are in serious debt and will need some kind of financial assistance. We can’t forget about the PIIGS (Portugal, Ireland, Italy, Greece and Spain), all of which have received bailouts already, and all of which will likely need more assistance in the near future.

Where will this money come from, and why should we care? Unfortunately, we need look no further than our own mirrors, because the reality is that the European Union simply doesn’t have the money to meet the needs of all of these countries. In fact, the money for these bailouts would need to come, proportionately (based on each member country’s GDP) from the very countries that need the bailouts. In essence, this is a giant game of hot potato, but these countries, neither individually nor collectively, can absorb the costs. At some point, probably through theInternational Monetary Fund, the EU is going to come calling, and we will be expected to foot the bill.

It would be easy to “just say no,” but the EU represents about 25 percent of the United States’ total annual GDP (they buy about a quarter of all of our output each year). We can’t afford to ignore the EU and we can’t afford for the EU to fail. The implications of a collapse of the EU are severe for them and for us, and for the entire global economy and financial system. We are, unfortunately, all in this together.

If Cyprus falls out of the EU due to a collapse of its banking system, I believe we will see a domino effect, with many other troubled countries also dropping out of the EU and returning to their home currencies. This will mean an end to the European Union in its current form. The major countries — Germany, France and the United Kingdom — would probably maintain some kind of economic union, and some would still use the euro, but the structure of the EU as we know it today would be permanently shattered.

We will have an answer this week as to the outcome for Cyprus and her banks. The real impact of this crisis will be felt for months to come as the challenges faced by the EU as a result of Cyprus are repeated over and over again, with other countries coming to terms with their financial problems. Although these countries may seem tiny and insignificant, they matter for U.S. financial markets and investors, and we need to keep a close eye on this crisis as it develops.


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