Published on March 28th, 2013 |
by Katharina Obermeier
Image © Jon Culver 2009
Cyprus, Economics and the Power of Perception
Most of us tend not to think too much about financial economics in our every-day lives. We take it for granted that the money in our bank accounts and wallets will always be more or less worth the same amount of stuff we want to buy, that the bank is a place that stores our money and returns it to us whenever we want it, and that shops will always be happy to accept the money we have in exchange for things we want. And most of the time, we are right to assume this – it means that the financial system is working properly. It is only when the system breaks down that we realise that the value of money can change dramatically from one day to the next, that banks are not liquid enough to pay out all the money in their customers’ accounts at once, and that shops only accept money in exchange for goods and services if they can reasonably expect to exchange that money for other goods and services they want, without any value being lost in the transaction. In other words, financial economics is underpinned by people’s assumptions and perceptions, and when those suddenly change, it can rock the entire system.
The current crisis in Cyprus is an excellent example of how this can happen. Last summer, the Cypriot government finally decided it had no choice but to apply for a bail-out from the EU’s rescue funds for the eurozone. Its banking sector, which had grown to an unsustainable size, had been hit hard by the bail-out deal for Greece, in which private investors had to take heavy losses. Cypriot banks were particularly exposed to this depletion, as they were closely involved in Greek investments. The Cypriot government had at first preferred to receive a “no strings” loan of €2.5 billion from the Russian Federation, but had to accept that any further loans from Russia would only be granted in coordination with an EU bail-out.
So, eurozone finance ministers, the IMF and the Cypriot government worked out the terms of a bail-out agreement – which is when the situation exploded. The agreed proposal would have applied a one-off levy of 6.75% to deposits under €100,000, while holders of larger deposits would have to pay 9.9%. Not surprisingly, Cypriots reacted with anger and attempted to withdraw their savings from their accounts in order to avoid the levy, quickly prompting banks to close and the government to impose capital controls to prevent money from leaving the country. An international outcry followed, as commenters were quick to turn on the EU for sanctioning this “daylight robbery”. The Cypriot Parliament overwhelmingly voted against the bail-out proposal, and intense negotiations had to be reinstated.
In the end, a new deal was hammered out. Cyprus’ second largest bank, Laiki, will be dismantled, while the Bank of Cyprus will undergo significant restructuring. Savings under €100,000 will be spared, while uninsured deposits could face significant losses. Essentially, this means that the Cypriot financial sector will undergo the severe restructuring it so badly needs, and that the biggest losers of the bail-out will also be the ones most likely to have profited from the earlier expansion of the financial sector, shareholders and bondholders.
Unfortunately though, the damage from the first proposal has already been done. Once the implicit trust between citizens and the financial system is broken, they have little incentive to play by the rules anymore. The perception that their government would go so far as to take their savings has been established, and it is difficult to imagine how the Cypriot government could re-establish that trust before suffering wide-spread bank runs and a large cash exodus from the island. Nor is it the only institution whose reputation has been blemished by the failed deal – the EU and IMF will undoubtedly receive the worst press coverage for the fiasco. This is in spite of the fact that it appears it was Cypriot President Nicos Anastasiades who insisted on imposing the levy on smaller deposits, as the only alternative was the break-up and restructuring of its two largest banks, which he feared would scare away Russian investors and depositors. Again, perception can be more powerful than the facts at hand. It is easy for a Cypriot politician to blame supranational organisations for unleashing disaster on the country when the public is already convinced of their failures.