Posted on 03 May 2013.
Why Cyprus is a Global Game-Changer
Last month, the European “troika” agreed to bail out the overextended banks in the tiny Mediterranean island-nation of Cyprus. The banks had made loans equal to nearly 8 times the size of the nation’s economy. As the local real estate market dropped, and the banks’ investment in Greek government bonds plunged in value, the banks became insolvent.
Because the banks were so big, there was no way the nation of Cypress could bail them out. So they called on the EU for help. After all, the EU had pledged hundreds of billions for Ireland, Portugal, Greece, and Spain.
But the troika’s tone had changed. They estimated a bailout would require €15.8B. They agreed to provide €10B, but the remaining €5.8 would have to be paid by those who “created the problem.”
A Very, Very Bad Idea…
But “those who created the problem” could not include the Cypriot government, which had no money; or the banks’ owners, who were broke; or those who lent money to the banks, who were too few in number to matter. That left one remaining group: bank depositors.
The troika decided that depositors with accounts below €100,000 would lose 6.75% of their funds, and accounts over €100,000 would lose 9.9%.
However, the Cypriot parliament refused to go along. As negotiations dragged on, the banks remained closed and the problem worsened.
Prior to “confiscation day” millions were secretly transferred out of Cyprus by those “in the know,” including €21M by relatives of the President (article). Some 132 parties transferred all their money out of the banks within two weeks before, according to Sigma (article).
Then, while the banks were supposedly closed during this negotiation, the banks’ foreign branches, including those in London and subsidiaries in Russia, actually remained open, and millions were transferred out. From Reuters:
While ordinary Cypriots queued at ATM machines to withdraw a few hundred euros as credit card transactions stopped, other depositors used an array of techniques to access their money.
No one knows exactly how much money has left Cyprus’ banks, or where it has gone. The two banks at the centre of the crisis – Cyprus Popular Bank, also known as Laiki, and Bank of Cyprus – have units in London which remained open throughout the week and placed no limits on withdrawals. Bank of Cyprus also owns 80 percent of Russia’s Uniastrum Bank, which put no restrictions on withdrawals in Russia. Russians were among Cypriot banks’ largest depositors.
…And the Sheep Get Sheared
Those unfortunate souls who didn’t know one of the political elites, or who didn’t know anyone in London or Russia, would end up paying the bill.
By the time the banks reopened, the capital needed far exceeded the original estimate of €15.8B, and the losses imposed on depositors needed to be far greater than 10%.
They finally agreed that deposits under €100,000 would be fully preserved, while those larger would bear the full brunt of the losses. Larger deposits would get only a fraction of their cash, the bulk of it converted into shares in the worthless bank. The latest estimates put the losses at between 60% for depositors at the Bank of Cyprus, and 80% for those at Laiki Bank (WSJ).
“I went to sleep Friday as a rich man. I woke up a poor man.”
Can you imagine waking up one day and your bank account is wiped out? From the Sydney Morning Herald:
“Very bad, very, very bad,” says 65-year-old John Demetriou, rubbing tears from his lined face with thick fingers. “I lost all my money.”
John now lives in the picturesque fishing village of Liopetri on Cyprus’ south coast. But for 35 years he lived at Bondi Junction and worked days, nights and weekends in Sydney markets selling jewelry and imitation jewelry.
He had left Cyprus in the early 1970s at the height of its war with Turkey, taking his wife and young children to safety in Australia. He built a life from nothing and, gradually, a substantial nest egg. He retired to Cyprus in 2007 with about $1 million, his life savings.
He planned to spend it on his grandchildren – some of whom live in Cyprus – putting them through university and setting them up. There would be medical bills; he has a heart condition. The interest was paying for a comfortable retirement, and trips back to Australia. He also toyed with the idea of buying a boat.
He wanted to leave any big purchases a few years, to be sure this was where he would spend his retirement. There was no hurry. But now it is all gone.
“If I made the decision to stay, I was going to build a house,” John says. “Unfortunately I didn’t make the decision yet.”
I expect most of those large accounts are operating accounts of local businesses. Can you imagine: having a large account balance because you are getting ready to pay a vendor, or payroll, and suddenly it’s all gone?
Most Cypriot businesses will struggle to survive. One firm related that its €400,000 account at Laiki Bank was frozen, leaving them unable to pay for a consignment of shoes.
Here is a blog post from a Cypriot business:
‘My bank account’s got robbed by European Commission. Over 700k is lost.
The most of circulating assets on our business Current Account are blocked.
Over 700k of expropriated money will be used to repay country’s debt. Probably we will get back about 20% of this amount in 6-7 years.
I’m not Russian oligarch, but just European medium size IT business. Thousands of other companies around Cyprus have the same situation.
The business is definitely ruined, all Cypriot workers to be fired.’
Businesses are the engine of wealth for a nation. They produce products people want to buy, and create jobs. Without a healthy business sector, the wealth of a nation will be destroyed.
During the crisis, banks were closed and ATM withdrawals were limited to €300 per day. People lined up for access to their cash:
But the banks couldn’t just reopen – people would rush to get their cash out, and the banks would again be at risk. So the plan had to include “capital controls” – limitations on people accessing their cash. The capital controls included (article):
- Checks cannot be cashed
- No more than €3000 can be carried across the border
- No more than €5000 per month can be spent on credit card/debit card purchases outside of Cyprus
- Commercial transactions over €500 must be proven to be in the “ordinary course of business”
These controls were supposed to last 7 days, but have already been extended, and they will be extended again, far longer than anyone will admit. Capital controls are always hard to lift. As soon as they are lifted, capital will flee Cyprus.
A Global Game-Changer
The global markets have mostly shrugged off Cyprus as insignificant. Indeed, the nation has only 1.1M inhabitants, equivalent to a mid-size city. And its GDP is just €28B, 500 times smaller than the US.
But in spite of its small size, Cyprus is a game-changer in several ways:
#1 Disregard for the Rule of Law
One of the greatest reasons for the prosperity of the west is high regard for the “rule of law.” This means that “the law is in charge” – rights and property are legally protected by well-established and proven laws and judicial systems; and thus risks can be measured and clearly defined. This is necessary for investment. For example, would you have second thoughts about investing in a business in Somalia, where there is no operating government or legal system?
Banks have capital structures that have been clearly defined by law and precedent for hundreds of years. The capital structure specifies that in a bankruptcy scenario, the first to take losses are the shareholders (owners); the next would be the creditors, those who lent the bank funds and received a return commensurate with the risk taken; only then would the depositors be affected. Depositors are further protected an explicit guarantee (the FDIC), in the US since the great Depression, and in Europe, an implicit protection since the financial crisis.
But the troika’s initial demands clearly gave no regard to any of this. Lenders to the bank, professional investors who weighed the risks and were paid handsome returns for assuming that risk, would face no losses; while depositors, who were more senior in the capital structure, and who had an implicit guarantee, would be plundered.
When I read this, I simply couldn’t believe it. A small group of officials were willing and able to circumvent well established legal precedent and deprive 370,000 people of their property, without any regard to law or due process. It is extremely disconcerting to investors to face such arbitrary decisions, where the only factor is political expediency.
For millennia the world endured the “divine right of kings,” to do whatever they pleased. The latin phrase that encapsulated this was “Rex Lex,” or “The King is Law.” Kings could do whatever they wanted – they were the law. In 1215 the Magna Carta was signed, which partially limited the right of the king for the first time in history.
In 1644, Samuel Rutherford reversed the phrase, writing a book called, “Lex Rex,” or “The Law is King.” He set forth the idea of the “rule of law,” where clear, fair laws are impartially applied to all situations, and no one is above the law.
In 1776, the US was founded on this idea, the first modern nation to do so. The central tenets of this ideal are captured in the US Constitution and the Bill of Rights, the 14th Amendment of which states, “nor shall any state deprive any person of life, liberty, or property, without due process of law.” Gradually rule-of-law became the dominant mode of governance. It is also one of the primary reasons for the unprecedented global prosperity achieved in the last 200 years.
But today, rule-of-law is at risk in Europe. If the troika can seize deposits, what can they not do? The new “kings” are policymakers. Their guiding principle is political expediency. They will readily take from anyone who cannot hurt them at the polls, either because they are not their constituents (just as Cypriot voters cannot hurt German Chancelor Angela Merkel at the polls) or they represent a small voting bloc (like the “rich”).
Clearly, today there is far greater risk of doing business in Europe than in other places. The mood is decidedly confiscatory, and the decision making is arbitrary and political.
The net effect is that investors will begin looking for the exits. Investment will slow in Europe, and capital will flee.
#2 Future Bank Runs
Depositor trust has been violated. After Cyprus, would you be concerned if you had a large deposit in a weak bank in Spain or Italy? You would right now be figuring out where and how to move it.
I am a student of the 1930’s financial crisis. Bank runs were common. From 1930-33 9096 banks failed; 4000 in the first two months of 1933 alone (FDIC). When a bank was rumored to be in trouble, the news would flash person-to-person and crowds would suddenly converge on the bank to withdraw their funds:
Bank runs in the US have all but ceased since the formation of the Federal Deposit Insurance Corporation (FDIC) in 1933, which guaranteed bank deposits up to $100,000.
Bank runs are always a risk in a “fractional reserve” banking system, which allows banks to lend substantially all of their deposits. The more people withdraw their deposits, the likelihood of default rises, triggering more withdrawals. A bank run thus wipes out the bank.
When the Cypriot banks reopened, officials were pleased that there were no crowds and people were orderly. But in today’s connected world, a bank run will not be accompanied by mobs crushing to get to a bank teller. Their money is a mouse click or phone call away. Billions can be transferred in seconds.
Today Deutschebank, one of the largest banks in Europe, is leveraged 60-to-1 – it has made $60 in loans for every dollar in equity capital. If they lost just 1.5% of their loans, they would be insolvent. Why on earth would a sane person keep their money at Deutschebank? One reason: the government guarantee.
Today, few people think much about which bank they should use – because of the guarantee. But all that has changed now – in Europe at least. The public has suddenly been made aware that a bank deposit is not the temporary storage of money, but an investment in a highly leveraged institution. Which in fact, it is.
The EU has destroyed trust in banks as a safe place to put money. This will have two impacts on the banks:
First, bank deposits will continue to accelerate their flight from the periphery states (Greece, Portugal, Spain, and Italy) to the core European banks. This will further endanger the already weak banks there.
Second, future bank runs on weak European banks are now quite likely. When it is clear a bank is in trouble, depositors will flee en-masse.
UK politician Nigel Farage summed it up like this (article):
Never did I think they would resort to stealing money from people’s savings accounts…
Now that they have done this in one country, they are quite capable of doing it in Italy, Spain and anywhere.
The message that sends to people is ‘get your money out while you can.’
He warns Europeans, “Do Not Invest In The Euro-Zone; you have to be mad to do so – as it is now run by people who do not respect democracy, the rule of law, or the basic principles upon which Western civilization is based.”
#3 Investments Will Rise
You may be surprised at this result – but as capital flees the European banking system, it will look for safe havens outside of banks, and many asset classes will benefit and rise in value: especially bonds, real estate, stocks and gold.
Money will also continue to flow out of Europe to safer places, like the US, Australia, Canada, and Switzerland to name a few.
#4: A Template for the Rest of Europe?
Jeroen Dijsselbloem, Dutch Financial Minister and president of the Eurogroup, stunned the financial world when he said that seizing depositor’s money could be a template for future bailouts. He immediately retracted the statement, denying that he said it, even though it is clearly documented that he did indeed say it.
French ECB Director Benoît Coeuré and many others quickly responded by stating explicitly that Cyprus was a unique situation and was not a model for future bank rescues.
But then ECB Governing Council member Klaas Knot said last night that there was “little wrong” with Dijsselbloem’s comment and that “the content of his remarks comes down to an approach which has been on the table for a longer time in Europe. This approach will be part of the European liquidation policy.” (Reuters) Europe is clearly endorsing depositor seizures!
Then Federico Ghizzoni. the CEO of Unicredit, Italy’s largest bank, then endorsed the idea of confiscating deposits: “uninsured deposits could be used in future bank failures provided global rule-makers agree on a common approach.” (Bloomberg) Holy smokes! What would you do if you had a large deposit in his very sick bank?
The reason they are saying Cyprus is unique is because its banks had little equity capital and few bondholders who could be stuck with the losses. The banks have financed themselves mostly through deposits, so they were the only ones who could absorb the losses.
But the ugly truth is that Cyprus is not as unique as they claim. Banks in Greece, Austria, Belgium, Slovenia, Spain, Portugal and the UK are at least 2/3 depositor-funded (see “Total Deposits” item on the chart from Credit Suisse above).
The banks in Europe remain badly overleveraged – meaning that they have made far too many loans relative to their capital base. From the above chart from Credit Suisse, we can calculate the bank leverage ratios. This chart shows the amount of loans they have made for each dollar of equity and reserve capital. You can see that most of the countries’ banks are far more leveraged than Cyprus:
As scary as these numbers are, they are quite optimistic because they are using the banks’ own rosy estimates. Obviously today Cyprus does not have 12% equity capital as the chart indicates. I have documented for years the accounting gimmicks banks use to boost their numbers.
Banks have loans go bad all the time. But the only times banks fail is when they are too leveraged – when they have made too many loans relative to their capital base. This is the real culprit. At 20x leverage, if a bank has just 5% of its loans fail it becomes insolvent. Such leverage makes bankers rich when times are good, but creates a massively unstable financial system.
Not only are the banks massively overleveraged, they are huge – “too-big-to-fail.” Even in “conservative” Germany, banks are 3 times larger than the entire economy of Germany. Switzerland’s banks are 8 times larger; Luxembourg is 13 times larger. It is insanity.
#5: Bank Stress to Increase
As already mentioned, Europe’s banks are leveraged to the hilt.
They already have to deal with the weak economy which causes their loans to go bad and recovery ratios worsen.
But the EU’s short-sighted response will accelerate capital outflows. This will put increasing pressure on the banks.
Furthermore the new Basel III rules are on the horizon. These rules require banks to hold much more capital relative to the number of loans they make.
For most banks this means raising capital from investors. But the EU’s decision will clearly make attracting the needed capital very difficult for the banks.
#6: Someone Has to Pay
So far, much of the damage from the financial crisis has been absorbed by governments and central bank “money printing.” But events in Cyprus make it clear there is no “free lunch.” These banks have lost billions in other’s money, and someone must pay.
When governments do bailouts, taxpayers will pay: through increased taxes, budget deficits, and decreasing government services, as we are now experiencing. People forget that the government cannot give anything to anyone except that it first takes it from someone else.
When central banks print money for bailouts, savers pay through increased inflation and decreased yields, as I wrote about in last month’s article, “Your Wealth is Now Being Transferred.” People forget that central banks cannot print goods or services, and that printing money simply dilutes the value of money relative to goods and services.
When central banks and governments do not do bailouts, then investors will pay; and when there are not enough investors, as in the case of Cyprus, then innocent bystanders will pay.
The bottom line is that those who have money will pay all the bills, one way or another.
#7 Depression Coming to Cyprus
The financial services industry in Cyprus is now dead. Big money is unlikely to return to Cyprus for decades. This matters, because financial services are 45% of the economy of Cyprus. Forty-five percent of Cyprus’ economy has just been vaporized.
Businesses in Cyprus are also cooked. Any cash they had has been confiscated, and many will not survive. Credit will be nearly impossible to obtain.
Add to this mix the Troika’s austerity program now in place (article):
- Increase in VAT taxes
- Increase in income taxes
- Freezing of pensions
- Increasing the retirement age
- Increasing fees for public services
- Increasing road taxes, registrations fees, and excise duties
- Reduction of pension entitlements
- Public sector layoffs
Together, this is a highly toxic brew for Cyprus. They will enter a very severe recession, probably the worst in Europe.
#8 Debt Slavery
Cyprus will go into this depression for the sake of a €10B bailout. Remember, this bailout is a loan, not a gift. It will push Cyprus’ debt-to-GDP ratio to 120% – unsustainable territory. Cyprus will likely enter a debt-trap – a situation where debt spirals out of control and cannot ever be repaid.
#9: Cross Border Contagion
The banking problem in Cyprus stemmed from two sources: 1) the economic crisis and housing crisis caused a number of loans to go bad; 2) much of the banks’ equity capital was held in Greek government bonds.
If you recall, in the Greek bailout, the troika forced investors in Greek government bonds to take a 50% loss. Once the dust settled, Greek bonds lost about 80% of their value. This decimated the banks in Cyprus. It was the bailout in Greece that substantially caused the problem in Cyprus.
Here is the point: when bailouts force losses on investors, it will hurt banks and pension funds, which will then need to be bailed out too. All the debt is interlinked. The problem in Europe is that there is simply too much debt, all interlinked, and all fragile. It is a sky-high debt pyramid, and a “house of cards.”
Europe has no “Plan B”
I admit to being amazed and somewhat mystified at Europe’s level of commitment to the Euro. It was enlightening to read ECB President Mario Draghi’s recent response when asked what would happen if Cyprus left the Euro. This was his answer:
‘Well you really are asking questions that are so hypothetical that I don’t have an answer to them. Well, I may have a partial answer. These questions are formulated by people who vastly underestimate what the Euro means for the Europeans, for the Euro area. They vastly underestimate the amount of political capital that has been invested in the Euro. And so they keep on asking questions like: “If the Euro breaks down, and if a country leaves the Euro, it’s not like a sliding door. It’s a very important thing. It’s a project in the European Union. That’s why you have a very hard time asking people like me “what would happen if.”’
Europe has proven their deep commitment to their single currency. But will-power cannot overcome the mathematical reality. The Euro has created massive economic imbalances between north and south. Their only choices are:
- Split into two Euros, north and south. The south Euro would drop by 30-40%, and the cheaper wages and costs would restart the economy.
- Reduce wages in the south by 30-40%. Not politically possible, though the current austerity-induced depression will probable achieve this if it continues for another 10-15 years.
- Eliminate the national sovereign budgets and go to a single budget and in essence, a single government. European nations would have to give up their sovereignty, just as the US states gave up their sovereignty to the US federal government. Only then could the Euro work.
- They could take the US, UK, and BOJ approach, and print money and bail out the banks and nations. However, the imbalances would remain and this would have to be repeated every 10 years or so.
The Iceland Solution
As long as Cyprus remains in the Euro, it will remain one of the most expensive places to do business. According to the IMF, the labor cost index, which measures the “fully loaded” cost of doing business, has risen even faster than in Greece, Spain or Italy since the late 1990s. Cyprus cannot hope to claw its way back to viability with a tourist boom because EMU membership has made it shockingly expensive. Turkey, Croatia and Egypt are all much cheaper. Manufacturing is just 7% of GDP.
Furthermore, Cyprus ranks very low on its international competiveness rank, Cyprus ranks below all European countries except Greece, Russia and Turkey (Cyprus Development Bank). The rank objectively measures countries in areas like “Burden of Government Regulation,” “Rigidity of Employment,” “Pay and Productivity,” “Ease of Starting a Business,” and “Extent of Investor Protection.”
If Cyprus remains in the Euro, it cannot recover until wages drop 40%. Cyprus must leave the Eurozone. Cyprus House of Representatives President Yiannakis Omirou has already called for the nation to leave the Euro (article):
There is no other alternative but to free Cyprus from the bonds of the troika and the memorandum, House of Representatives President Yiannakis Omirou has said.
Omirou talked about the troika demands, which according to him will multiply and will turn Cyprus to a colony of the worst possible type and warned “I would like to send a message to the Cyprus people that there is no other way, there is no alternative apart from freeing (the country) from the troika’s and the memorandum’s bonds”.
He noted that certainly, “this road will demand sacrifices”, adding that “by leaving the troika and the EMS behind us, we will ensure our national independence, our national sovereignty, our moral integrity and our economic independence”.
“If we remain bound by the Troika and the memorandum Cyprus’ destiny is already foretold and there will be no future”, he pointed out.
He is calling for an Iceland-like solution, which I have written about many times.
Iceland suffered severely in the 2008 financial crisis. Unlike other nations, Iceland refused to bail out their banks. Unemployment spiked up to 10%. The Icelandic stock market crashed 95%:
Iceland has its own currency, the Krona, which also crashed by about 50%:
This sounds bad, but it is actually long-term positive. The crashed currency caused imports to double in cost, but it also made exports 50% cheaper. Icelandic export industries like aluminum and fishing began booming. Because its currency is so low, today entrepreneurs are profitably growing tomatoes in greenhouses, in a country just miles from the Arctic Circle! As a result, the economy of Iceland is recovering – due in large part to the weaker currency.
Unemployment continues to drop. Compare the unemployment in Iceland to Greece:
Economies will always self-adjust in time – and exchange rates are the cornerstone of this self-adjustment. But this mechanism cannot function in Southern Europe because they are bound to the Euro.
Bob Fraser | Director & Founder of Joseph International
Robert Fraser founded an e-commerce provider for business customers, including Xerox, Chase Manhattan Bank, and Samsung. He raised $44 million in investment capital and guided the company to an average of 20 percent month-to-month revenue growth over 6 years, becoming the Kansas City metro area’s fastest growing company between 1997 and 1999. In 2000, Fraser received the Midwest Region Ernst and Young Entrepreneur of the Year Award. Today Fraser is Director of Joseph International, a ministry dedicated to restoring a vision for the marketplace.
For more information or to receive Fraser’s FREE economic newsletter, visit www.josephinternational.org and click “Joseph Insight”.