Cyprus became the latest euro zone domino to teeter in 2012 just when the worst of the crisis appeared to be over. In March 2013, a compromise rescue plan backed by euro zone finance ministers called for Cyprus to wind down one largely state-owned bank, Popular Bank. The raid on Popular Bank was intended to raise most of the 5.8 billion euros that Cyprus was required to raise as part of the bailout.
Cyprus' bailout marks a turning point
What has set Cyprus apart is that it is one of the smallest members of the euro zone, with a failed banking system much bigger than its economy. Likewise, the €10 billion (HK$101 billion) rescue deal with international lenders, though more than half its GDP, is small change compared with the hundreds of billions in bailouts for Greece, Spain, Portugal and Ireland. But it marks a turning point in European leaders' approach to bailouts, with the balance of risk shifted from taxpayers to private investors.
While bank accounts and deposits under €100,000 have been spared a levy, deposits in the largest bank could take a haircut of around a third, and big deposits at the second biggest could be wiped out. The reaction of European bank shareholders underlines the disconnect between recovery in the markets and growth-challenged real economies. First news of the 11th-hour deal lifted bank shares. But after remarks by the head of the Eurogroup about shifting the balance of risk to investors, shares in big Italian and French banks fell sharply over concerns about the exposure of deposits in future bailouts.
That said, it is a timely reminder to the finance sector about responsibility in risk-taking, as Europe struggles to balance public austerity with the need for economic growth to finance debt repayment. For Cyprus, which no longer has a future as an offshore banking haven, it ushers in economic contraction and rising unemployment, without the option of currency devaluation to improve trade competitiveness.
The deal does allow the government to impose some capital controls, though this is a contradiction in terms, since freedom to move money characterises a monetary union. In recognition of the dangers to the currency area and single market inherent in such controls, the Eurogroup finance ministers said, rightly, that they should be temporary. The fact that capital controls imposed by non-euro-zone-member Iceland in 2008 remain in place shows that can be easier said than done.