Mishandling of Cyprus in monetary union goes back to its entry and is serious stain on record of EU institutions

Cyprus could still upset the euro area

It is by no means impossible that one small country, such as Cyprus, could set off a chain of events which spread across the whole euro zone. Euro zone policy makers should be thankful that the Cyprus debacle has not so far had a severe adverse effect on the rest of the euro zone, particularly given political paralysis in Italy. They should not be complacent that there will be no such contagion. So far Cyprus is the only country where opinion polls have shown a majority wanting to leave the euro zone, reflecting a deep sense of betrayal. If one country, albeit a small one, leaves the euro zone, the possibility that others might do so is likely to be more prominent in investors’ and depositors’ minds. A key factor against leaving is the threat to savings of being compulsorily changed into a much weaker currency. The Cyprus deal has now led to a loss of savings over €100,000 of up to 50%, although the belated decision to protect savings up to this threshold has reassured those with moderate savings.

 

The principle of moral hazard has been applied brutally and selectively

Given the small size of the Cyprus economy and therefore of its required bail-out relative even to those of Ireland and Portugal, it is surprising that the key creditor countries, Germany, the Netherlands and Finland, did not agree to the whole €17bn needed, or at least to leave a much lower amount to be lost by depositors. One reason is election politics in such creditor countries, particularly given publicity over the fact that a significant proportion of the depositors being bailed out would be Russian investors and would include many tax evaders (both Russian and non-Russian) and might indeed include worse forms of money laundering. Another, perhaps better, reason is that bailing out an irresponsibly over-stretched financial sector would cause “moral hazard” by setting a precedent of bailing out irresponsible behaviour on the part of banks. It may be desirable that depositors look to how well banks are being managed and so give earlier warning of financial crises by withdrawing money from poorly managed banks anywhere in Europe. However, the risk is that sensible caution turns in to an exit stampede from not just one or two badly managed banks but from all the banks of one or more countries.

Secondly avoidance of moral hazard should apply to all not just the ill-starred deposit-holders in Laiki Bank and the Bank of Cyprus. Why should not banks in core euro zone countries including German banks have been forced to take losses on their ill-judged loans to Irish banks rather than forcing all the losses to be shouldered by the Irish taxpayer? Why has a Netherlands’ bank recently been fully bailed out by the state?

 

EU institutions should take responsibility for leading Cyprus up the garden path

Even more important, the EU institutions, including the European Central Bank, European Commission and the European Council (meaning the member states especially the most influential ones) should take responsibility for their gross negligence towards Cyprus. Eight times its GDP in Cypriot owned bank balance sheets are eight times the country’s and unlike Switzerland for example, the banks had little experience of risk management on such a scale until the expansion began in the 1990s. In addition, an excessive amount was invested in one basket, that of Greek government bonds, even if it were not evident that Greek public finances were amongst the weakest in Europe. A weakness lay in the Maastricht treaty itself limiting euro admission criteria to macro-economic and fiscal indicators and not including the viability of banking systems, and in the lack of regulatory powers at the euro zone level, but warnings could still have been made by ECB and other institutions. While Greece has to accept a large part of the blame for its predicament because it did not follow clearly laid down rules on public finance management, Cyprus did not disobey any such rules. By being admitted to the euro zone, it was in fact being led up a garden path into a supposed area of stability which turned out to be the opposite. There is little wonder that Cypriot deposit holders, such as small to medium businesses, who may have lost up to half their savings feel betrayed. It is too late for a U-turn. But measures should be taken to enable Cyprus to rebuild a service economy on stronger foundations. The size of the country means that a small proportion of EU structural funds could make a significant impact if used well.