Cyprus: the rescue plan that backfired on Brussels

It’s a measure of the mishandling that this drop of an economy, just 1.1m people and 0.2pc of eurozone GDP, has been able to trigger such a tsunami, reports The Telegraph.

The €10bn (£8.6bn) bail-out plan – pocket change compared to funds sunk into Greece, Ireland and Portugal – has engulfed global markets, wiping billions from the value of companies around the world, particularly the fragile banks. It has flooded the minds of investors, bond traders, and savers with fear. And it has doused the careful work of “Super” Mario Draghi to restore confidence in Brussels to keep the eurozone afloat.

The bail-out itself was no surprise: Cyprus has been sailing close to the wind for years. Its current account deficit hit 17.5pc of GDP in 2008 while its banking system was obviously dangerously oversized at nine times GDP. The banks have been highly exposed to Greek banks and sovereign debt too.

Cyprus first applied for a bail-out in June last year. The troika henchmen were held back, partly because of the Communist-led government which refused to countenance the sale of any state assets to help fund a bail-out. However a bigger problem was the clientele of Cypriot banks. Over the years the lenders have attracted thousands of rich foreigners, particularly Russians, but they have also gained a reputation for being centres for money-laundering. European leaders, particularly those with mutinous electorates in the north, baulked at the idea of bailing out non-EU depositors, let alone those of dubious legality.

Cyprus’ election last month removed the political blockage while its deteriorating finances made a bail-out urgent. President Nicos Anastasiades said the money was needed to avoid imminent “disorderly bankruptcy.”

Over the weekend, the euro group unveiled the €10bn rescue but triggered shock and alarm by including as a condition an “up-front, one-off stability levy applicable to resident and non-resident depositors”. Presumably they had the foreign depositors in mind, and on one level it worked. VTB, the state-owned Russian bank, could lose €1.3bn. Vladmir Putin, the Russian president, condemned the deal as “unfair, unprofessional and dangerous.” But in its determination to exclude outsiders, Brussels has inflicted extraordinary harm on itself and its members too.

In a single stroke they also removed the protection of bank depositors. The principle, which has guaranteed savings of up to €100,000, has been crucial in maintaining consumer confidence – and, at times, has alone prevented a catastrophic run on the banks.

As traders and analysts reacted with horror, European politicians appeared to realise their mistake and backtrack. But the message was out: savings could be used to bail-out banks. “Policy makers have broken the taboo of hitting depositors,” said analysts at RBS. “This will hurt peripheral mid-sized banks, and may create contagion across credit markets. We remain cautious on bank sub debt in Spain and Italy.”

Ilya Spivak, Currency Strategist at DailyFX, said: “The level of panic evident across financial markets likely reflects fears of the precedent that EU officials are setting. As with Greece, investors are transposing what is happening now Cyprus to what a similar course of action might look like were to be implemented in a country like Spain, where a sickly banking sector is likewise at the centre of the country’s malaise.”

The timing couldn’t be worse. Italy, the eurozone’s third biggest economy, is in political limbo while Portugal and Spain are languishing in a deep economic slump. Over the next week, Greece, Spain, Portugal and Italy are planning to tap the bondmarkets for much needed cash.

The Cypriot vote to approve the deal has been delayed, apparently while some radical changes are made. It’s a waiting game for savers whose money remains locked in Cypriot banks until at least Thursday. Investors in Cyrprus and the EU may not be so patient.