What happened in Cyprus?

Economystifed reader Aaron B. requested a post on the situation in Cyprus. 

There is a bit of kinda technical, arcane stuff that goes into this story.  But I promise, its a story worth knowing.  It's full of great drama, and like all good epic tales, Russia is shows up.

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Context

In 2007-2008, the US financial crisis, precipitated by the bursting of the mortgage bubble, kicked off a chain of events that led to economic downturns in places all over the world, eventually reaching the tiny island nation of Cyprus.

These recessions were caused by banks' inability and unwillingness to borrow money from each other.  

These jams in credit markets were caused by two problems that feed into each other:  First, there was just less disposable cash lying around that institutions could lend out.  Second, there was enough doubt, uncertainty, and shaken confidence in everyone's economic prospects that no institutions really wanted to make loans, even if they could.

This pinch made it harder for banks to give out loans and credit to their customers, which cramped businesses' and individuals' finances.  This put pressure on the Cypriot economy.

And note that when the private sector economy shrinks, its government feels the pinch too.  Governments get all their spending money by collecting taxes.  When sales are slow, and personal incomes and business profits are low, there's not as much tax revenue.

Not to mention Cyprus - like many nations - offers unemployment insurance and public assistance to the needy.  When an economy shrinks, more people will be meeting that definition of "needy," and be eligible for benefits.

So now we have a situation where the Cypriot govt is collecting less revenue, but legally on the hook for more expenses.  Eek!

Anyway, the credit-cruch felt the world over led to a jump in unemployment in Cyprus, and to property markets to bottoming out.  In 2009, the Cypriot GDP shrank by 1.67% compared to the previous year.  The foul economy put all sorts of strain on the Cypriot govt's finances, of course, as more citizens fell into the social safety net.

(SIDE NOTE - All over the world, the health of housing markets are a serious factors in the overall economic health of a nation.  This is because in most nations, houses are the most valuable thing citizens will ever own.  If you're interested in this topic, check out the the economist Robert Shiller.  He's sort of the guru when it comes to housing economics.)

Ok, so that kinda sums up the initial problem.  Up next: how did the Cyprus handle the situation?

Cypriot banks: where the snowball began to roll

Before launching into the Cypriot reaction to the recession, there's one other piece of the puzzle I forgot to mention.  The Cypriot financial systems had huge connections to other nations' economies, particularly Russia and Greece.

Cypriot banks moonlight as an "off-shore" banks for wealthy Russians and Russian businesses.  Meaning if Russian corporations or rich individuals want to hide some of their money from the tax man in Russian, Cypriot banks make it easy for them to stash money with them.

Also, Cypriot banks had loaned a lot of money to banks and govts in Greece, a nation Cyprus is very close with, culturally, politically, and economically

So here we have Cyprus, with a population of 1 million people, and a GDP of roughly $23 billion a year, ending up with a banking sector that was sitting on almost $90 billion (€70 billion) (about half of that money is believed to have come from Russia).

This sort of overloaded a lot of Cypriot banks.  Oodles of cash flowed in from Russia, and Cyprus' banks did what banks do - they lent it out.  But with so much money on hand, they loaned to pretty much anyone - especially in Greece.

Keep in mind, for a bank, customers' money is both and asset, and a liability.  Sure, Cyprus' banks had $90 billion to lend out.  But they also technically owed $90 billion to its customers at home and abroad at the same time. 

When the Cypriot economy contracted in 2009 this put tons of pressure on the banks.  People and businesses started defaulting on loans left and right.  They put away less and less away into their savings, or actually dipped into them.  And when the Greek economy crashed, the banks lost even more of their money.

Their reserves were running low, and there was the fear that withdrawls would surpass on-hand cash reserves.  If this happens, the banks, in effect, would be losing customers money.

Fearing a bank run they couldn't handle, Cyprus' banks decided they needed to raise A LOT of quick cash.

So the banks turned to their government, and asked for a loan that could balance out what they owed with what they had on hand - because, like anyone who ever has watched a gangster movie knows, not being able to pay your debts to "the Russians" is really bad.

The govt obliged.  But now the Cypriot govt was short on funds, funds desperately needed to, you know, run a government.

Goodness, what a mess!!

The Russian Loan
Long story short, Russia ended up coming to the rescue in early 2012.

Which is really weird!!  You'd figure Russia would be loathe to help out Cyprus, who has been helping the national elite avoid taxes for years and years.

(SIDE NOTE - Russia also is a world pioneer in cronyism and state corruption.  I'm not implying that the Russian govt would ever use public money to help prop-up banks enabling wealthy Russians to avoid paying their taxes.  But I am saying *wink, wink*.)

We'll just say that Russia was a gentleman and floated about $3 billion to the Cypriot govt, to help them out short-term.  That freed up some Cypriot govt money to bail out its banks.

But Russia's got its own problems, it couldn't manage to cough up any more.  And now the long-term problems were kicking in for Cyprus.  Everyone's confidence in Cyprus' economy, banks and govt was shot, and a sort of panic set in.  This did not help their economy one bit.   

The European Bailout

In June 2012, Cyprus' govt officially asked for a bailout of €17 billion from the European Stability Mechanism (Cyprus is on the Euro), citing their exposure to the Greek crisis and the strain it was putting on Cyprus' banks (directly) and government (indirectly).

The plan was to use that money to stabilize the banks, in hopes that would stabilize the general economy, in hopes that that would bring back govt revenues and everything would be hunky dory.

That bailout didn't come until March 2013.  It took so long for political reasons, not economic ones.  After the bailouts in Ireland, Greece, Portugal and Spain, Europe was not in the mood for another.

Ultimately, the European Commission, European Central Bank and International Monetary Fund pooled together €10 billion, and offered it as a loan to Cyprus.  But refused to kick in the full €17 billion, on account of them being sick of loaning to everyone all the time all of a sudden.

So where was the other €7 billion going to come from?  They Cypriot govt came up with a plan:

They would seize 7% of every bank account in the nation under €100,000, and 10% of each one above.  On the day of the announcing that plan, every bank in Cyprus was forced to stay closed, and every ATM shut off.

I image that was a VERY scary day in Cyprus.  People felt like they were being robbed, and can you blame them?  It would be hard to avoid an "us vs them" mentality toward your govt in that situation, when pulling together as a nation would undoubtedly be better for everyone.

This was about the point in the saga when the whole thing started making the news.  It was a dramatic moment, lots of protests in Cyprus, as well as in other nations.  The plan just seemed unfair, you know?

Anyway, the seizure plan was eventually dropped.  What Cyprus ended up with was the closure of Laiki Bank, the second largest bank in Cyprus.  Its bad loans were written off, its good ones transferred to the relatively healthier Bank of Cyprus.  With this mass write-off, the other €7 billion was no longer needed.

Where are we now?

Cyprus has some time to pay off that loan.  So it's too soon to tell whether or not the bailout "worked."

Now, €10 billion really isn't a lot of money.  But with Cyprus already in debt, and the country so small to begin with, its now in a position where the govt's total debts have grown to 150% of GDP.  

How likely are they to be able to pay-off that debt?  Imagine a guy making $50,000 a year, but owes the credit card company $75,000.  How long would it take to pay that off?  5 years?  10, maybe?

As of the start April, Cypriot "bank transactions are capped at €25,000, daily cash withdrawals are limited to €300 and cheques cannot be cashed."  Not to mention three supreme court judges are to be put on trial, and "Michalis Sarris, the finance minister, who resigned on April 2nd after only five weeks in the job" ("The Blame Game" - The Economist).

Sounds to me like the banks are still afraid of runs, and everyone's trying to figure out to blame of the whole mess.  We're not out of the woods yet.

And most foreboding (I think), the Cypriot govt's credit, right now, is shot.  This will make it difficult for them to borrow money in any circumstance.

In fact, now rated as 'CCC', a lot of public funds and most banks won't even be able to legally loan money to Cyprus.  An IOUs from the Cypriot govt is junk.  Meaning even if they just need extra funds for regular day-to-day operations, they might need to request a bailout.  Not good.

The big picture

It was the mortgage crisis in the US that set off chain reaction that sent Greece into a spiral.

It was the Greek failure that sent Cyprus to the Euro Zone for a bailout.

Cyprus will need to get its banking sector in order to service their loan.  This will upset the Russian oligarchy that uses Cyprus as a tax haven.

And so a homeowner in California got in over his head on a mortgage causing diplomatic tensions between the Russian Duma and European Commission.  

A butterfly flaps its wings in Central Park, causing a tsunami in Japan.

Its a crazy world we live in, isn't it?