The Brussels/Frankfurt/Washington/Nicosia Axis
Following a week of protests, long lines at the ATM machines of closed banks, a Russian rebuff to Cypriot pleas to help its banks, a no vote by the Cypriot parliament to a joint EU/Cypriot government proposal to tax depositors' bank accounts, and a breakdown last night of negotiations with an EU/IMF team in Nicosia, Cypriot President Nicos Anastasiades decided to seek assistance at a higher level. He and his Finance Minister flew to Brussels this morning, on a private jet provided by the European Council, to meet with European Union leaders, including Council President Herman Van Rompuy and Commissioner President Jose-Manuel Barroso, IMF Managing Director Christine Lagarde, and the head of the European Central Bank, Mario Dragy. Meeting on the same issue, also on an emergency basis, was the EU's bloc of 17 Finance Ministers.
This is the latest round in the ongoing Euro Zone debt/political crisis, manifesting itself this time in Cyprus - an island economy, about one quarter the size of that of Cincinnati, Ohio, and accounting for 0.2% of Euro-Zone GDP, the bloc to which it was admitted in 2008. Size does matter here, though, clearly not of the Cypriot economy, but of the country's commercial banking system, which functions inter alia as an offshore tax haven, and holds deposits roughly three times, and assets about eight times, the size of the domestic economy. Wealthy Russians and other non-residents have maintained large, liquid deposits in the Nicosian banks. The banks have, in turn, made substantial loans to Greek enterprises, and hold Greek debt. Thus, they have borrowed short, and loaned long - as all banks do - but having been caught in Greece's financial meltdown, much of their asset base is now, at best, worth far less than book value, at worst, worthless. Cyprus's two largest banks, in particular, the Bank of Cyprus and Laiki, are bankrupt.
Thus, the Cyprus emergency has arisen. Cyprus is bust, and cannot afford to bail out its banks. Early last week, the EU/ECB/IMF (the so-called "Troika"), concerned that a bank run, even in tiny Cyprus, could be systemic within the rest of the Zone, and ultimately affect the viability of the euro, stepped forward with a 10 billion euro bail-out proposal. But, on German/IMF insistence, the loan would be conditional on Cyprus coming up on its own with an additional 5.8 billion, by levying a tax on the deposits in the Cypriot banks, even on those below 100,000 euros that by European law are covered by deposit insurance. The loan proposal, designed to both recapitalize the banks and restructure the country's debt, backfired, angrily rejected outright by the Cypriot parliament, who called it "bank robbery".
New proposals were made just before President Anastasiades left for Brussels. By tomorrow, if no deal has been struck, the ECB has said it will stop its emergency lending, without which Cyprus's banks will be completely illiquid. This would cause a banking collapse and almost certainly push Cyprus out of the euro. Then, with this precedent, what might Greek, or Spanish, or Irish, or Portuguese, or even Italian depositors decide to do?