Cyprus

Who might have thought the financial disposition of Cyprus would have an effect on the quality of our economic performance?

This whole week, and in the weeks ahead, the world’s money men had their eyes focused on the small island state in the Mediterranean. Cyprus just joined the PIGS (Portugal, Italy, Greece and Spain) in the list of Eurozone countries flirting with default.

Every small development in Cypriot politics created shockwaves in the global financial market. The stock markets around the world swayed wildly, including our own. The world’s main currencies entered another episode of extreme volatility, affecting the trade of vital commodities such as oil.

Cyprus exhibits a characteristic similar to Iceland’s before that other small country, a few years ago, initiated this long bout of volatility in the Eurozone. The Cypriot banking sector was actually larger than its real economy.

The Icelandic banks absorbed a large mass of funds from British banks. In the good times, this fact produced incredible prosperity for the small population of this distant island economy. When the large mainland banks ran into trouble, the Icelandic banks collapsed. The shock waves ran across the Eurozone.

The Cypriot banking system, for its part, handled tens of billions of euros from Russian corporations. For years, Cyprus undercut the other European banks by pushing down taxes on deposit earnings to become the banking haven it was until the present crisis happened. It proved more efficient for Russian conglomerates to deposit their euro-denominated funds in Cypriot banks than in any other Eurozone bank. To a significant extent, too, dirty Russian money was laundered in Cyprus.

Cyprus experienced an economic boom hosting thousands of wealthy Russian tourists searching for warmer holiday destinations. It is believed Moscow was courting Cyprus for warm water ports for its ships. In a word, the Cypriot economy increasingly became an extension of Russia’s economy even as it was a Eurozone country.

When Cyprus’ debt became unsustainable and its banking system unstable, the country went to the European Central Bank (ECB) for bailout money. The ECB’s power rose the past few years as the euro crisis prolonged.

Last week, the ECB demanded a truly draconian measure as conditionality for extending bailout money to Cyprus. Considering the Cypriot banking system is larger than its real economy, the ECB demanded the government of Cyprus impose a one-time, across-the-board levy on all bank deposits. This means basically confiscating 10% of every depositor’s hard-earned money, the small saver as much as the large conglomerate.

The ECB was very likely targeting the large amount of Russian funds deposited in Cypriot banks. The drastic measure, however, will be resisted by small Cypriot depositors.

I personally think this is such a stupid prescription.

First, it torpedoes depositor confidence throughout the Eurozone. If Cypriot depositor’s money could be so arbitrarily confiscated by the state, every Eurozone citizen’s deposits will be perceived to be at risk. There will be large-scale withdrawals and capital flight — a scenario that could bring down the larger European banks.

Second, between the announcement of the measure and its actual enforcement, there will be capital flight out of Cyprus. That will only worsen the financial problems this economy is already experiencing.

Since this stupid prescription was announced, the euro began falling. That indicates more people jumping out of the euro for other currencies. All the member countries of the Eurozone will be penalized by a falling euro.

At any rate, the citizens of Cyprus reacted to the proposed measure by streaming out to the streets, protesting loudly. Earlier this week, the Cypriot parliament voted down the proposal. In the meantime, the Cypriot banking system has been shut down to avert capital flight — although the long banking holiday also chokes the domestic economy.

Next week, the ECB, in the face of rejection by Cypriot politicians sensitive to the noise in the streets, will most likely deny Cyprus bailout money. In anticipation of that eventuality, Cyprus approached Russia towards the close of the week, appealing for euro 5 billion in emergency bailout funds to service the country’s debts.

The word in the market is that Russia will not likely entertain the request. By their calculation, this is a losing proposition.

Recall that a couple of years ago, then French president Nicolas Sarkozy travelled to Beijing, hat in hand, asking China to buy into euro bonds to help prop up the volatile currency. The Chinese did not accede to the request. It simply did not make business sense for them to convert from the strong dollars in their reserves to the falling euro.

Should the ECB deny Cyprus bailout money and force this economy into default, it will be like shooting oneself in the foot. A defaulting member of the Eurozone weakens the entire common currency structure and undermines the stability of the currency itself.

By the end of this week, the outlook is for the euro to weaken as major funds migrate out of the currency to flee to safer havens, particularly in the emerging economies. This could reflect in, for instance, a stronger peso in the near term and an upsurge in our stock market.

The benefit is only for the short-term, however. The inflow of euro-based funds seeking safe havens also means that the emerging economies will also be importing the volatility characterizing the Eurozone. Unless the search for safe havens come in the form of direct investment, all the hot money euro flows bring, like the bacteria the conquistadors brought to the new world, imply volatility into the longer term for emerging markets.