Cyprus’s parliament has said no to the bailout plan that would have forced bank depositors to hand over a share of their savings. So now what? Here are three paths Cyprus could take.
Of course, Cyprus would be walking into uncharted territory both politically and economically. No one’s exactly sure how things would work. But the general outlines are clear. The island’s entire banking system would collapse. Those banks are ultimately reliant on the European Central Bank (ECB) to fund their operations. Depositors who are upset over a 7% or 10% levy on their deposits would get the opportunity to lose substantially more, likely through some sort of forced conversion back to the Cypriot pound, which would be rapidly falling in value. Inflation would explode. Hard currency would flee. Cypriot businesses would effectively default on all of their external obligations by paying them off in a different currency than agreed to. The economy would go into a sharp downturn.
But maybe it wouldn’t be the end of the world. The saga of Iceland—another small island with a stupidly large banking system that collapsed—suggests that in some instances a sharp, painful devaluation could be just the thing for a country that finds itself in a Cyprus-like situation. There’s one key difference, however. Iceland was never on the euro. A Cypriot departure from the euro zone could be much messier.
Previous efforts made to shore up banking systems in the euro zone, such as Ireland’s, didn’t touch depositor money. Cyprus could try for something like that. While effectively insolvent, it does have some leverage. The triumvirate that is managing the slow-motion debt crisis—the EU, IMF and ECB—has tried to move heaven and earth to avoid any exits from the the European Union. A Cypriot exit might not do much direct damage, but it would set a precedent for a much larger country to leave, with traumatic consequences. The troika might rustle up €5.8 billion—the amount that was supposed to be raised from the tax on depositors—sooner than let that happen.
But of course, that would recreate the problem the original plan was supposed to avoid, that of saddling Cyprus’s government with debt it can’t handle.
Cyprus has done it before. The Russians have already extended Cyprus a €2.5 billion three-year loan at below-market rates of 4.5%. Cypriot finance minister Michalis Sarris was en route to Moscow today in an attempt to try to extend that loan. Of course, Russia’s deep ties to Cyprus’ less-than-pristine banking system are part of the reason why Europe wanted to make depositors in Cyprus pay the bailout bill instead of giving it to European taxpayers.
At the very least, the Russia card is worth a try. And it could prompt European officials to relent somewhat on their tough bailout terms, as more Russian influence on the euro zone would likely be an unappealing prospect in Brussels.