Europe's Disturbing Precedent in the Cyprus Bailout

March 26, 2013 | 0900 GMT

By George Friedman
Founder and Chairman

The European economic crisis has taken different forms in different places, and Cyprus is the latest country to face the prospect of financial ruin. Overextended banks in Cyprus are teetering on the brink of failure for issuing loans they cannot repay, which has prompted the tiny Mediterranean country, a member of the European Union, to turn to Brussels for help. Late Sunday, the European Union and Cypriot president announced new terms for a bailout that would provide the infusion of cash necessary to prevent bankruptcies in Cyprus' banking sector and, more important, prevent a banking panic from spreading to the rest of Europe.

What makes this crisis different from the previous bailouts for Greece, Ireland or elsewhere are the conditions Brussels has attached for its assistance. Due to circumstances unique to Cyprus, namely the questionable origin of a large chunk of the deposits in its now-stricken banking sector and that sector's small size relative to the overall European economy, the European Union, led by Germany, has taken a harder line with the country. Cyprus has few sources of capital besides its capacity as a banking shelter, so Brussels required that the country raise part of the necessary funds from its own banking sector -- possibly by seizing money from certain bank deposits and putting it toward the bailout fund. The proposal has not yet been approved, but if enacted it would undermine a formerly sacred principle of banking in most industrial nations -- the security of deposits -- setting a new and possibly destabilizing precedent in Europe.

Cyprus' Dilemma

For years before the crisis, Cyprus promoted itself as an offshore financial center by creating a tax structure and banking rules that made depositing money in the country attractive to foreigners. As a result, Cyprus' financial sector grew to dwarf the rest of the Cypriot economy, accounting for about eight times the country's annual gross domestic product and employing a substantial portion of the nation's work force. A side effect of this strategy, however, was that if the financial sector experienced problems, the rest of the domestic economy would not be big enough to stabilize the banks without outside help.

Europe's economic crisis spawned precisely those sorts of problems for the Cypriot banking sector. This was not just a concern for Cyprus, though. Even though Cyprus' banking sector is tiny relative to the rest of Europe's, one Cypriot bank defaulting on what it owed other banks could put the whole European banking system in question, and the last thing the European Union needs now is a crisis of confidence in its banks.

The Cypriots were facing chaos if their banks failed because the insurance system was insufficient to cover the claims of depositors. For its part, the European Union could not risk the financial contagion. But Brussels could not simply bail out the entire banking system, both because of the precedent it would set and because the political support for a total bailout wasn't there. This was particularly the case for Germany, which would carry much of the financial burden and is preparing for elections in September 2013 before an electorate that is increasingly hostile to bailouts.

Even though the German public may oppose the bailouts, it benefits immensely from what those bailouts preserve. As I have pointed out many times, Germany is heavily dependent on exports and the European Union is critical to those exports as a free trade zone. Although Germany also imports a great deal from the rest of the bloc, a break in the free trade zone would be catastrophic for the German economy. If all imports were cut along with exports, Germany would still be devastated because what it produces and exports and what it imports are very different things. Germany could not absorb all its production and would experience massive unemployment.

Currently, Germany's unemployment rate is below 6 percent while Spain's is above 25 percent. An exploding financial crisis would cut into consumption, which would particularly hurt an export-dependent country like Germany.

Berlin's posture through much of the European economic crisis has been to pretend it is about to stop providing assistance to other countries, but the fact is that doing so would inflict pain on Germany, too. Germany will make its threats and its voters will be upset, but in the end, the country would not be enjoying high employment if the crisis got out of hand. So the German game is to constantly threaten to let someone sink, while in the end doing whatever has to be done.

Cyprus was a place where Germany could show its willingness to get tough but didn't carry any of the risks that would arise in pushing a country such as Spain too hard, for example. Cyprus' economy was small enough and its problems unique enough that the rest of Europe could dismiss any measures taken against the country as a one-off. Here was a case where the German position appears enormously more powerful than usual. And in isolation, this is true -- if we ignore the question of what conclusion the rest of Europe, and the world, draws from the treatment of Cyprus.

A Firmer Line

Under German guidance, the European Union made an extraordinary demand on the Cypriots. It demanded that a tax be placed on deposits in the country's two largest banks. The tax would be about 10 percent and would, under the initial terms, be applied to all accounts, regardless of their size. This was an unprecedented solution. Since the global financial crisis of the 1920s, all advanced industrial countries -- and many others -- had been operating on a fundamental principle that deposits in banks were utterly secure. They were not regarded as bonds paying certain interest, whose value would disappear if the bank failed. Deposits were regarded as riskless placements of money, with the risk covered by deposit insurance for smaller deposits, but in practical terms, guaranteed by the national wealth.

This guarantee meant that individual savings would be safe and that working capital parked by corporations in a bank was safe as well. The alternative was not only uncertainty, but also people hoarding cash and preventing it from entering the financial system. It was necessary to have a secure place to put money so that it was available for lending. The runs on banks in the 1920s and 1930s drove home the need for total security for deposits.

Brussels demanded that the bailout for Cypriot banks be partly paid for by depositors in those banks. That demand essentially violated the social contract on the sanctity of bank deposits and did so in a country that was a member of the European Union -- one of the world's major economic blocs.

Proponents of the measure pointed out that many of the depositors were not Cypriot nationals but rather foreigners, many of whom were Russian. Moreover, it was suggested that the only reason for a Russian to be putting money in a Cypriot bank was to get it out of Russia, and the only motive for that had to be nefarious. It followed that the confiscation was not targeted against ordinary people but against shady Russians.

There is no question that there are shady Russians putting money into Cyprus. But ordinary Cypriots had their money in the same banks and so did many Cypriot and foreign companies, including European companies, who were doing business in Cyprus and need money for payroll and so on. The proposal might look like an attempt to seize Russian money, but it would pinch the bank accounts of all Cypriots as well as a sizable amount of legitimate Russian money. Confiscating 10 percent of all deposits could devastate individuals and the overall economy and likely would prompt companies operating in Cyprus to move their cash elsewhere. The measure would have been devastating and the Cypriot parliament rejected it.

Another deal, the one currently up for approval, tried to mitigate the problem but still broke the social contract. Accounts smaller than 100,000 euros (about $128,000) would not be touched. However, accounts larger than 100,000 euros would be taxed at an uncertain rate, currently estimated at 20 percent, while bondholders would lose up to 40 percent. These numbers will likely shift again, but assuming they are close to the final figures, depositors putting money into banks beyond this amount are at risk depending on the financial condition of the bank.

The impact on Cyprus is more than Russian mafia money being taxed. All corporations doing business in Cyprus could have 20 percent of their operating cash seized. Regardless of precisely how the Cypriot banking system is restructured, the fact is that the European Union demanded that Cyprus seize portions of bank accounts from large depositors.
From a business' perspective, 100,000 euros is not all that much when you are running a supermarket or a car dealership or a construction company, but this arbitrary level could easily be raised in the future and the mere existence of the measure will make attracting investment more difficult.

A New Precedent

The more significant development was the fact that the European Union has now made it official policy, under certain circumstances, to encourage member states to seize depositors' assets to pay for the stabilization of financial institutions. To put it simply, if you are a business, the safety of your money in a bank depends on the bank's financial condition and the political considerations of the European Union. What had been a haven -- no risk and minimal returns -- now has minimal returns and unknown risks. Brussels' emphasis that this was mostly Russian money is not assuring, either.

More than just Russian money stands to be taken for the bailout fund if the new policy is approved. Moreover, the point of the global banking system is that money is safe wherever it is deposited. Europe has other money centers, like Luxembourg, where the financial system outstrips gross domestic product. There are no problems there right now, but as we have learned, the European Union is an uncertain place. If Russian deposits can be seized in Nicosia, why not American deposits in Luxembourg?

This was why it was so important to emphasize the potentially criminal nature of the Russian deposits and to downplay the effect on ordinary law-abiding Cypriots. Brussels has worked very hard to make the Cyprus case seem unique and non-replicable: Cyprus is small and its banking system attracted criminals, so the principle that deposits in banks are secure doesn't necessarily apply there. Another way to look at it is that an EU member, like some other members of the bloc, could not guarantee the solvency of its banks so Brussels forced the country to seize deposits in order to receive help stabilizing the system. Viewed that way, the European Union has established a new option for itself in dealing with depositors in troubled banks, and that principle now applies to all of Europe, particularly to those countries with financial institutions potentially facing similar problems.

The question, of course, is whether foreign depositors in European banks will accept that Cyprus was one of a kind. If they decide that it isn't obvious, then foreign corporations -- and even European corporations -- could start pulling at least part of their cash out of European banks and putting it elsewhere. They can minimize the amount of cash on hand in Europe by shifting to non-European banks and transferring as needed. Those withdrawals, if they occur, could create a massive liquidity crisis in Europe. At the very least, every reasonable CFO will now assume that the risk in Europe has risen and that an eye needs to be kept on the financial health of institutions where they have deposits. In Europe, depositing money in a bank is no longer a no-brainer.

Now we must ask ourselves why the Germans would have created this risk. One answer is that they were confident they could convince depositors that Cyprus was one of a kind and not to be repeated.

The other answer was that they had no choice. The first explanation was undermined March 25, when Eurogroup President Jeroen Dijsselbloem said that the model used in Cyprus could be used in future bank bailouts. Locked in by an electorate that does not fully understand Germany's vulnerability, the German government decided it had to take a hard line on Cyprus regardless of risk. Or Germany may be preparing a new strategy for the management of the European financial crisis. The banking system in Europe is too big to salvage if it comes to a serious crisis. Any solution will involve the loss of depositors' money. Contemplating that concept could lead to a run on banks that would trigger the crisis Europe fears.

Solving a crisis and guaranteeing depositors may be seen as having impossible consequences. Setting the precedent in Cyprus has the advantage of not appearing to be a precedent.

It's not clear what the Germans or the EU negotiators are thinking, and all these theories are speculative. What is certain is that an EU country, facing a crisis in its financial system, is now weighing whether to pay for that crisis by seizing depositors' money. And with that, the Europeans have broken a barrier that has been in place since the 1930s. They didn't do that casually and they didn't do that because they wanted to. But they did it.


March 25, 2013, 7:07 p.m. ET

The Great Recession Has Been Followed by the Grand Illusion

Don't be fooled by the latest jobs numbers. The unemployment situation in the U.S. is still dire.



The Great Recession is an apt name for America's current stagnation, but the present phase might also be called the Grand Illusion—because the happy talk and statistics that go with it, especially regarding jobs, give a rosier picture than the facts justify.

The country isn't really advancing. By comparison with earlier recessions, it is going backward. Despite the most stimulative fiscal policy in American history and a trillion-dollar expansion to the money supply, the economy over the last three years has been declining. After 2.4% annual growth rates in gross domestic product in 2010 and 2011, the economy slowed to 1.5% growth in 2012. Cumulative growth for the past 12 quarters was just 6.3%, the slowest of all 11 recessions since World War II.

And last year's anemic growth looks likely to continue. Sequestration will take $600 billion of government expenditures out of the economy over the next 10 years, including $85 billion this year alone. The 2% increase in payroll taxes will hit about 160 million workers and drain $110 billion from their disposable incomes. The Obama health-care tax will be a drag of more than $30 billion. The recent 50-cent surge in gasoline prices represents another $65 billion drag on consumer cash flow.

February's headline unemployment rate was portrayed as 7.7%, down from 7.9% in January. The dip was accompanied by huzzahs in the news media claiming the improvement to be "outstanding" and "amazing." But if you account for the people who are excluded from that number—such as "discouraged workers" no longer looking for a job, involuntary part-time workers and others who are "marginally attached" to the labor force—then the real unemployment rate is somewhere between 14% and 15%.

Other numbers reported by the Bureau of Labor Statistics have deteriorated. The 236,000 net new jobs added to the economy in February is misleading—the gross number of new jobs included 340,000 in the part-time, low wage category. Many of the so-called net new jobs are second or third jobs going to people who are already working, rather than going to those who are unemployed.

The number of Americans unemployed for six months or longer went up by 89,000 in February to a total of 4.8 million. The average duration of unemployment rose to 36.9 weeks, up from 35.3 weeks in January. The labor-force participation rate, which measures the percentage of working-age people in the workforce, also dropped to 63.5%, the lowest in 30 years. The average workweek is a low 34.5 hours thanks to employers shortening workers' hours or asking employees to take unpaid leave.

Since World War II, it has typically taken 24 months to reach a new peak in employment after the onset of a recession. Yet the country is more than 60 months away from its previous high in 2007, and the economy is still down 3.2 million jobs from that year.

Just to absorb the workforce's new entrants, the U.S. economy needs to add 1.8 million to three million new jobs every year. At the current rate, it will be seven years before the jobs lost in the Great Recession are restored. Employers will need to make at least 300,000 hires every month to recover the ground that has been lost.

The job-training programs announced by the Obama administration in his State of the Union address are sensible, but they won't soon bridge the gap for workers with skills in science, technology, engineering and mathematics. Nor is there yet any reform of the patent system, which imposes long delays on innovators, inventors and entrepreneurs seeking approvals. It often takes two years to obtain the environmental health and safety permits to build a modern electronic plant, a lifetime in the tech world.

When employers can't expand or develop new lines because of the shortage of certain skills, the employment opportunities for the less skilled are also restricted. To help with this shortage, the administration's proposals for job-training programs do deserve support. The stress should be on vocational training, postsecondary education and every program that will broaden access to computer science and strengthen science, technology, engineering and math in high schools and at the university level.

But the payoffs from these programs are in the future, and it is vital today to increase the number of annual visas and grants of permanent residency status for foreigners skilled in science and technology. The current situation is preposterous: The brightest and best brains from all over the globe are attracted to American universities, but once they get their degrees America sends them packing. Keeping these foreigners out means they will compete against us in the industries that are growing here and around the world.

What the administration gives us is politics. What the country needs are constructive strategies free of ideology. But the risks of future economic shocks will multiply so long as we remain locked in a rancorous political culture with a leadership more inclined to public relations than hardheaded pragmatic recognition of what must be done to restore America's vitality.

Mr. Zuckerman is chairman and editor in chief of U.S. News & World Report.
Copyright 2012 Dow Jones & Company, Inc. All Rights Reserved

March 25, 2013 5:37 pm

Brazil: Humbled heavyweight
Growth has stalled and the government is casting about for revival measures
Children play near cable cars that cross over Complexo do Alemao, Brazil©AFP

Robert Lima da Silva sits on the ageing motorbike he uses for his job as a courier, waiting for one of São Paulo’s torrential rainstorms to pass.

“I’ve got a motorbike from 2003 and I want to change it for something newer,” he says. But he explains that repayments on his existing debts account for about two-thirds of his monthly income. “The problem is that my debts won’t let me,” he says of the planned upgrade.

Brazil’s motorcycle industry reflects a wider malaise in Latin America’s biggest economy. Two-wheeler sales were growing quickly until 2011, when millions of new lower-income consumers took advantage of easy access to loans to buy a new Honda or Yamaha. Last year, however, that changed as consumer credit became harder to secure, causing production to plunge by more than a fifth. It is a trend that has continued into this year.

Like many other Brazilian manufacturers, the motorcycle industry is now looking to the federal government in Brasília to help solve its problems. They know that the government of President Dilma Rousseff is desperate to revive the country’s former economic miracle. Gross domestic product grew less than 1 per cent last year, the lowest of the Brics club of emerging nations.

Investors are shunning Brazil in preference for Mexico, something unthinkable only two years ago. Although she is still immensely popular, the economy is a potential cloud over Ms Rousseff’s re-election prospects next year.

Her government’s response has been to wade into sectors ranging from energy to telecommunications with a mixture of carrot and stick, from tax incentives to measures forcing producers to cut prices. Yet rising government involvement in business is proving divisive.

On one side, those in banking and the financial markets argue that Brazil is reverting to interventionist ways that were found want­ing in the past. The industrial sector counters that manufacturing will sink under high costs and rising imports unless help is forthcoming.

Brazil vehicle registration, credit to individuals and average wages in manufacturing

The one point of consensus seems to be that the past decade of external tailwinds, provided by robust commodity prices and generous foreign fund inflows from loose monetary policy in developed markets, is over. Brazil needs to fuel its internal engines of growth, particularly investment.

“We are basically talking about what is the potential growth of Brazilhow much Brazil could grow in this new world with commodities not pushing, with developed countries not growing, this is a question [for which] we don’t have an answer today,” says Roberto Setubal, chief executive officer of Itaú Unibanco, Brazil’s biggest private bank. “Clearly Brazil has to change the model.”

Intervention in Brazil can make or break an investor’s fortunes overnight. In March, shares of Petrobras leapt 9 per cent after the government unexpectedly allowed the state-controlled fuel company to increase diesel prices. While the government officially denies controlling petrol prices at the pump, Petrobras is forced to sell fuel from its refineries at below international levels to help control inflation, depleting cash reserves needed to develop Brazil’s giant offshore oilfields.

“It was a positive surprise,” says Brunella Isper at Aberdeen, a São Paulo fund management company. “Maybe the government is signalling it is not that keen to use Petrobras any more as a tool to control inflation, which would be great if true.”

The surge of interventionism dates back to 2009 when Brazil began what it dubbed the “currency war”. The government was worried that foreign speculators were pouring money into Brazil to exploit the country’s high interest rates, in the process driving up the value of the currency against the dollar and hurting the competitiveness of local industry. The episode reached a climax in 2011 when Brazil raised financial transaction taxes on everything from bonds and swaps to foreign loans in order to curb the inflows.

Eventually, the real did weaken. Although the International Monetary Fund cautiously approved currency controls, various economists have questioned the currency war’s value. Nomura economist Tony Volpon argues the currency controls cut off foreign portfolio inflows and damaged investor sentiment just as the economy was slowing down in mid-2011 because of the eurozone crisis. This partly explains why Brazil screeched to a halt faster than other emerging economies – from 7.5 per cent GDP growth in 2010 to 0.9 per cent last year. Worse, the weaker currency seems to have done little to revive industry, which is plagued by high costs and wage rises that are outstripping productivity.

“The imposition of capital controls led to a tightening of monetary conditions just as growth began to disappoint,” Mr Volpon said in a report.

Apart from the currency, the government reverted to direct protection. The big four car manufacturers in Brazil Fiat, Volkswagen, General Motors and Ford – won a reprieve in 2011 from competition from cheap Asian imports. Excise tax rose up to 30 percentage points on cars with less than a certain level of local content, stopping some Korean and Chinese producers in their tracks.

. . .

In its bid to save jobs, the government began cutting social welfare taxes for 40 industries. Companies applauded the move. But the ad hoc nature of the changes led to more uncertainty in the investment climate, economists argued. Jin-Yong Cai, the chairman of the World Bank’s private-sector arm, the International Finance Corporation, told the Financial Times: “Business looks for stability and transparency and it’s not good to give special treatment to one industry or another which in my view creates distortions.”

In the second half of 2011, the central bank began a dramatic easing cycle, bringing its benchmark Selic rate down to what is for Brazil a record low of 7.25 per cent. Yet Ms Rousseff was dismayed when banks refused to increase lending. What ensued was a messy public spat with the private banks, which resisted exhortations to increase lending, arguing that Brazilians were already too heavily indebted.

“For Brazil, the issue is that consumer spending, which for years was the driver of growth, can no longer continue to increase at rapid rates,” said Capital Economics, a London-based research house.

After the failure of these earlier interventions to return growth to its higher track, official policy took a more strategic turn last year. Ms Rousseff began targeting Brazil’s high costsBrazil ranks 130th out of 185 countries on the World Bank’s Doing Business survey – below Bangladesh and Russia but above India. She also began trying to boost Brazil’s low investment ratio, which at 18 per cent of GDP last year is below Mexico at 21.5 per cent and Chile at nearly 24 per cent.

First came giant infrastructure programmes. More controversially, the government also renegotiated expiring electricity concession agreements to give operators the choice of extending immediately – in exchange for a sharply lower tariff – or face their contracts being put up for tender when they expired. This sent electricity stocks crashing, angering investors, but it won applause from industry associations.

Critics argue the end result was that while foreign companies remained bullish last year, ploughing $65bn in direct investment into Brazil, the plethora of changes created so much uncertainty that domestic investors and foreign fund managers began withholding their money.

Excessive interventionism has a cost, it was probably 200 basis points altogether in Brazil last year of growth,” said Marcelo Salomon, economist at Barclays Capital.

Others, however, see some of the interventions as important attempts to move Brazil further down the development path and tackle the notorious custo Brasil or Brazil cost. Interest rates charged by banks on some consumer products, such as overdrafts, soared into triple digits. Ms Rousseff’s campaign to lower rates was an attempt to deal with this.

Brazil has the highest ratio of renewable hydropower electricity at nearly 82 per cent last year. Yet Brazilians pay among the world’s highest energy bills. The government’s intervention in electricity lowered energy costs 14 per cent this year, according to Itaú-Unibanco.

The government is pursuing other reforms, too, that barely register on the investor radar: Ms Rousseff wants to double education investment to 10 per cent by 2020 and she is overseeing an improvement in the rule of law by showing less tolerance for corruption among her ministers and in her party.

“Even though investors take a view that the moment you intervene it is wrong, what investors want doesn’t always necessarily imply what is good for the country itself in the long term,” says Haroon Sheikh of Netherlands-based Cyrte Investments.

The history of rapid development in northeast Asia, such as South Korea’s state-led focus on education and its use of the chaebol business groups to develop value-added industries, were examples of successful interventions. Mr Sheikh adds, however, that not all intervention is good.

Subsidies, local-content programmes, protection, tax breaks and cheap credit should be accompanied by strict guidelines to ensure that industries become globally competitive or cease to receive such benefits. A crucial part of successful east Asian industrial policy is “being able to let things that are not important die and focus on others”, Mr Sheikh says.

. . .

There is a growing sense that the most frenetic phase of the intervention may be ending. A more assertive central bank is pushing back on inflation and threatening to increase interest rates. The fuel-price rise and a promise by officials to improve returns on infrastructure projects were taken as a sign by investors that the government is still listening. The economy seems to be responding, with better growth coming through in January.

Political analysts say that although a more methodical approach to economic reform is needed, Ms Rousseff will probably continue to walk a tightrope between providing concessions to politically important industries and launching more comprehensive changes. If industry begins laying off workers, it would hurt her re-election prospects and provide a boost for new presidential challengers, such as Eduardo Campos, a charismatic governor in the booming northeast state of Pernambuco.

Perhaps for this reason, Marcos Zaven Fermanian, president of Abraciclo, Brazil’s motorbike and bicycle manufacturers’ association, remains confident that help could be on the way for his industry.

“The state-owned banks have increased the volume of finance to our customers but there is still space for further growth,” he says.

Mr da Silva may be able to upgrade that motorcycle after all.

Copyright The Financial Times Limited 2013.