Cyprus Financial Crisis: A simple explanation

Up until a week ago, investors were in euphoria because stocks were reaching new all-time highs. On March 14, 2013, the Dow Jones closed at a record 14,539.14 — a level not seen since pre-subprime mortgage crisis of 2007. Philippine stocks, meanwhile, continued its upsurge, ending at its all-time best of 6,835.21 on March 7, 2013.

And then last week, the market reversed. After reaching a new all-time high, the Dow Jones slid and was unable to return to record levels. The Philippine Stock Exchange index suffered a decline and, as of yesterday, registered its eighth consecutive day of losses.

What happened, you ask? Blame it on the Cyprus financial crisis.

Where is Cyprus?

Most Filipinos are unaware where Cyprus is and with good reason. A member of the European Union, Cyprus is a relatively small island country in the Eastern Mediterranean Sea in Europe, located east of Greece, south of Turkey and north of Egypt.

Its land area is a mere 9,251 square kilometers — less than half the size of Region XI (Davao Region). The population of Cyprus stands at around 1.1 million, almost equal to the combined population of the cities of Makati and Las Pinas.

Its nominal Gross Domestic Product (GDP) is around $24 billion, representing a relatively insignificant 0.2% of the total GDP of the European region. With its seemingly minute size, why then did it have a big impact on global stock markets last week?

To understand this, we need to know what was going on in Cyprus prior to last week’s scramble.

The Greek contagion

Cyprus’s location and cultural proximity to Greece explains why 77% of the country’s population are Greek. This Greek affinity became a burden to the country when Greek sovereign bonds were downgraded to junk status in 2010. The Cypriot government and banking institutions took a big hit because of their large exposures to Greek debt (see The “Greek Debt Crisis” explained).

Despite austerity measures, Cyprus sunk further into recession in recent years. In 2012, the country’s GDP contracted by 2.3%. To cover its budget deficit, the country requested help from Russia and was given a 2.5 billion euros (€2.5 billion) emergency loan, subject to a 4.5% interest per year.

But the Russian support barely made an impact to uplift the country’s sagging economy. In the same year, credit rating agencies downgraded Cypriot sovereign rating to junk status. This further increased the country’s borrowing cost. The government then decided to seek a bailout from the European Union.

The EU bailout

In late 2012, several negotiations were conducted as regards the terms and conditions of the bailout. In exchange for funding, the European Union wanted “strong austerity measures, including cuts in civil service salaries, social benefits, increases in VAT, tobacco, alcohol and fuel taxes, taxes on lottery winnings, property, and higher public health care charges”. As expected, Cypriots did not take those demands sitting down. Public demonstrations arose in protest against the plan.

Eventually, the European Union and the International Monetary Fund (IMF) approved the Cyprus bailout plan on March 16, 2013. This made Cyprus the fifth country to receive money from the EU-IMF after Greece, Ireland, Portugal and Spain. The deal, however, has a catch.

EU rejected Cyprus’s initial request of 17 billion euros (€17 billion) of bailout money, agreeing to provide only 10 billion euros (€10 billion) — with the remaining to be raised by the country. Specifically, the EU wanted Cyprus to generate 5.8 billion euros (€5.8 billion) through a tax levy on deposits in Cypriot banks.

The Cypriot bank deposit tax

The bank deposit tax, proposed by the EU, is a tax levied on existing deposits made on Cypriot banks. The tax will not be made on interest income earned on the deposit but, instead, on the actual deposit balance.

The proposal is to charge a one-time tax of 6.75% on bank accounts with deposit balances between 20,000 euros and 100,000 euros and 9.9% on accounts with balances higher than 100,000 euros ($129,290 or PHP 5.3 million). This means high-value depositors can see their deposits reduced by almost 10% in an instant.

The levy appears to be outright sequestration, and the government planned to sequester the cash while banks are closed for a public holiday. Although citizens can make small withdrawals via ATMs, the government ruled that banks will remain closed until Thursday this week to prevent depositors from making large withdrawals.

The EU is said to pursue the tax on bank deposits because they believe the Cypriot banking industry has grown so big that it has become unsustainable for a small country such as Cyprus. Data shows that total deposits in Cypriot banks amount to more than five times the country’s GDP. The EU wants a reduction in the size of the country’s banking sector, and sequestration could allegedly help achieve this goal.

In addition, most of the high-value depositors are said to be members of the Russian elite who channel their funds to offshore banking services in Cypriot banks as a way of escaping political uncertainty and corruption in Russia. The EU, in a way, plans to control the inflow of funds from Russians who may use Cypriot banks for money laundering.

Parliamentary veto

Expectedly, the Cypriot public and politicians voiced their objections to the deal. Several Cypriots went to the streets and rallied against the plan, calling on the EU to “keep their hands off” Cyprus.

On March 19, 2013 the Cyprus parliament voted to reject the bailout plan, with 36 members voting against and 19 abstaining.

As of today, the EU and Cyprus government are working on a new bailout plan — the results of which would determine if Cyprus would plunge further into recession or emerge out of it in a few years’ time.

Sources: Yahoo News, Bloomberg

You must read these other interesting articles:

• The “Greek Debt Crisis” explained
• Meaning of Credit Ratings by Rating Agencies
• 2013 Moody’s Bond Ratings by Country
• U.S. credit rating downgraded by S&P