This picture is from a website for Cypriot homes: you can buy a three bedroom apartment for £1.6mn. Whoever owns that — property developer or individual and whichever bank lent them the money to develop or buy it — now risks being wiped out. And this is just the beginning. Here are a few thoughts on this situation.
1. The downfall. Cyprus was a problem amplified by political incompetence, a disaster that never should have happened. The outlook is exceeding bleak for this small economy and the economic pain coming to the 800,000 inhabitants will be severe. Why? Because the banking industry got so giant – at seven times the economy - and it is about to shrink rapidly. If you take 20 per cent off your depositors (a guess at the moment), then as soon as they can, they will take their money elsewhere. The Cypriot banking crisis has only just begun.
As the powers that be gather tonight, it is becoming increasingly clear that the wealthy depositors of over 100,000 Euro will be taking a large haircut. There is a lot of speculation, rumour and misinformation, but I have seen numbers anywhere between 10-40 per cent depending on the bank. I hope the bond holders are wiped out entirely as should be the case and I hope the insured depositors of under 100,000 are left intact. That does now appear to be the case.
2. Capital controls: inevitable. Clearly Capital controls are needed to prevent depositor flight - restricting the cash that can be taken out of any Cypriot bank will need to be imposed to prevent a full collapse. But who will be subject to them? All depositors or just the large ones? I can’t see how the government could restrict ordinary Cypriots from getting to their money - if they do so they risk losing elections forever. But although the small insured depositors now look like they’re safe from the “savings tax”, they will know that the first plan was to take 6.75 per cent of their cash. Why would they leave money in a Cypriot bank knowing this? Small depositors make up a large part of the overall depositor base. If they can take their money out, expect them to. And then as soon as the capital controls are lifted for everyone else, expect that money to flee to Switzerland or other tax and regulatory havens. Cyprus may have wanted to protect its banking industry but that desire is frankly delusional.
How capital controls sit within the EU’s principal of Free Movement of Capital I am unsure – I am not a lawyer. But rich Russians can afford good legal advice.
3. Depositor Flight + Leverage = costly chaos. Once depositor flight gets going, the real damage begins thanks to leverage. When a bank gets in E1 of deposits, it doesn’t lend out E1, it lends out E20, E30, E40. Hence when E1 is taken out, the loan book needs to shrink many more times. Depositor flight will cause significant more damage to Cypriot banks, forcing them to recall loans, sell their loan books, all of which often cause default. What ensues is messy — a brutal credit crunch and collapsing property prices. The pain is only beginning as its the depositor flight that causes the real agony.
What we learnt form the Irish banking and property collapse, is that the original estimate of the cost of the bailout was way too optimistic. The final cost of sorting out Cypriot banks will be multiples of the original £17 billion.
4. And then: contagion. Footage of queues of people outside Northern Rock was broadcast all over the globe. Bank runs make headlines. When Cypriot banks re-open and savers finally get a chance to access their cash, the resultant shots will be aired all over Europe. It will cause Europeans to wonder if their savings are safe.
5. Cyprexit? Does it matter if Cyprus exits the Euro? We just don’t know. The economic pain will be severe for the country and the resultant depreciation in any new currency will make a 6.75 per cent savings tax look tiny. But it does raises the possibility of another country leaving. And that means that the ECB’s threat to do 'whatever it takes to save the Euro' and the fear market players have for the central bank is eroded. Borrowing costs for Italy and Spain, that have remained low, may increase once more. It raises the possibility of a catastrophic and costly Euro break-up again.
6. Angry Germans. I understand why Germany is forcing Cyprus to contribute to the cost of its bailout – voters are unhappy to help rich Russian oligarchs secure their money in a tax and regulatory haven. I understand the moral hazard created from helping the irresponsible and profligate. But frankly €6bn is a rounding error in the Commissions’ annual accounts. It is so irrelevant a sum and yet by not spending it immense damage is threatened. At some point Germany needs to decide if it wants to save its cherished Euro and if it does, it needs to get the cheque book out (and not just loan documents).
7. Cypriot banks will be in intensive care for years. Once depositor flight begins, bank deleveraging will be extreme and the resultant credit crunch and property collapse highly damaging to the local economy. Losses will mount and the banks will need help again. Do not believe the initial costs for this mess. Cypriot banks will need more help in the future.
This is not the last of the pain. A generation of Cypriots will be hurt.
Louise Cooper, is a former Goldman Sachs banker and BBC journalist. She blogs at coopercity.co.uk