Cyprus: Canary In The Coal Mine?

Another country bites the dust.

The dominant news item this week is that Cyprus has reached the point of no return without a financial rescue. By itself, the failure of such a tiny economy would have virtually no effect on the broader world economy, notwithstanding the tremendous pain inflicted on direct creditors of the government or the country’s banks. Cyprus’s economy is roughly the size of Vermont’s. How this local crisis unfolds, however, could have far wider repercussions.

The banking system in Cyprus is far larger relative to the size of the economy (about eight times) than comparables in the rest of the world. The United States banking system, for example, is about the same size as the country’s GDP. Cyprus’s banks bet heavily on Greek debt, trusting that rescues ultimately would produce big profits. On the contrary, losses were huge when Greek debt was restructured.

Eurozone monetary authorities have proposed a rescue plan, but have insisted that Cyprus’s banks bear a sizable part of the financial burden. The initial plan, since rejected by the legislature, was to tax bank deposits up to 100,000 euros at 6.75% and above 100,000 euros at 9.9%. Depositors both large and small screamed at such confiscation, especially because - at least at the lower level - deposits had been guaranteed, much as deposits in the United States are guaranteed by the FDIC.

Russia is expressing heavy displeasure, its citizens having deposited an estimated $12 billion in Cypriot banks. Many in the Eurozone suspect that much of that money may be the product of “Russian Mafia” activities. Understandably, that suspicion lessens Eurozone members’ willingness to contribute to a bailout.

Unable to deal with the problem expeditiously, Cyprus has closed its banks until at least next Tuesday. A primary concern is that open bank doors might lead to runs on the banks. An even greater concern throughout the Eurozone is that depositors in financially challenged larger countries like Spain and Italy might begin to pull assets out of their domestic banks. In an already precarious financial situation, the last thing heavily indebted countries want to see are pictures on the nightly news of lines of scared depositors streaming down the sidewalks outside major banks. Such fears can become highly contagious.

Following the rejected tax on depositors, several proposed solutions have emerged, including tapping public pension funds. There is no clear Plan B. Hope remains strong, however, that the other members of the Eurozone will ultimately pony up needed rescue money, rather than allow Cyprus to drop out of the 17-nation monetary union.

It is not at all clear which is the more powerful force: antipathy of Eurozone members toward providing more rescue money or fear of unknown consequences should Cyprus have to leave the union. Should they leave, revalue their old currency and begin to recover, there could be a parade of others-led by Greece-that start down the same path.

While acknowledging that Cyprus’s default would barely register on the world financial scale, my first reaction was that this could be today’s version of the assassination of the Archduke Ferdinand, which line I used at a meeting yesterday. I thought it was a clever analogy until I heard two others use it today on financial TV. Let’s instead wonder whether Cyprus could be the canary in the coal mine.