Did The Bailout Of Cyprus Change The Tone Of The European Crisis?

source: http://www.flickr.com/photos/alfmelin/

source: http://www.flickr.com/photos/alfmelin/

There’s a lot to be said about the highly controversial bailout of Cyprus. International markets, already on edge in the wake of the 2008 financial crisis and still struggling with low or negative growth, went into red alert a few weeks ago when Cypriot President Nicos Anastasiades first asked for assistance. It’s clear that the event changed the tone of the conversation about Europe’s economic condition, but it’s too early to tell what the full effects will be.

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Cyprus was the fifth nation to formally seek emergency financial assistance from the Troika, a coalition of European Union finance ministers, the European Central Bank, and the International Monetary Fund responsible for ensuring euro zone economic stability. By the time the call for help went out, Cyprus was juggling a banking system with assets equal to 750 percent of its 2012 GDP, which was about $24 billion. Meanwhile, the Troika was juggling complicated and politically tense multibillion-euro bailouts in four major economies.

As central bank balance sheets grew fat with the bonds of countries in the throes of debt crises, the patience of finance ministers and policymakers wore thin. With this as a backdrop, Cyprus’s bailout package was designed by frustrated and fatigued creditors who were unwilling to engage in the limitless and effectively free support mechanism originally established during the formation of the European economic and monetary union.

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Invoking the risk-adverse spirit of previous Bundesbank policymakers — that is, maintaining that concerns about domestic inflation and economic stability supersede the bailout of foreign nations, even if they are in the currency bloc — German finance ministers led a controversial initiative to force Cypriot depositors to carry a majority of the burden of the bailout.

Cypriot policymakers rejected the ECB’s initial proposal to charge all deposits in the nation between 6.7 and 9.9 percent. With this off the table, the ECB threatened to end emergency liquidity assistance to Cyprus unless the nation implemented some sort of official plan to address the crisis. Many have come to see this threat as a tipping point in the greater European economic recovery.

Previously, the ECB maintained relatively generous emergency liquidity assistance to other bailout nations such as Ireland and Greece. Through these agreements, this money traditionally won’t stop flowing unless two-thirds of the governing council vote to close it down. This has left major economies like Germany disgruntled with the growing size of its ECB assets, particularly those that reflect ECB loans to nations in financial crisis. Bundesbank short-term liquidity transfer assets make up nearly two-thirds of its balance sheet.

Convention states that the Bundesbank should be forced to intervene in the event of an economic crisis that threatens the stability of the currency bloc, but thanks to a 35 year old agreement the German central bank has the right to withdraw its support, should the circumstances warrant it.

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It seems like the situation in Cyprus warranted invoking the spirit of this agreement — the Emminger letter, which has a long and relevant history in the origin story of the European Monetary System. The Bundesbank has apparently examined its own economic condition and the relative instability of the currency bloc and opted not to extend an infinitely generous hand to Cyprus.

The deal that was ultimately reached resulted in the closure of the nation’s second-largest bank and substantial losses on deposits of more than 100,000 euros. One of the great concerns is that the ECB and and other European nations will seek similar terms with any other European country seeking assistance.

Don’t Miss: Bank of Cyprus Deposits Could Evaporate This Insane Amount.

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