Broken Cyprus Bows to Its New Eurozone Masters

”For a small, open economy like Cyprus, euro adoption provides protection from international financial turmoil.”

European Central Bank President Jean-Claude Trichet, welcoming Cyprus into the European single currency in 2008.

Cyprus has agreed to a ten billion euro ($13bn) deal with eurozone and IMF leaders to bail out its banks, and to prevent the Mediterranean island nation from exiting the European single currency. However, Cypriots can be forgiven for not taking to the streets to wave flags and honk their car horns. They’re finding out just what the “protection” afforded by the euro looks like, and it’s more akin to the kind offered by ski mask-wearing heavies in certain parts of New Jersey than the financial security Monsieur Trichet promised.

Under the terms of the deal, the country’s second-largest bank will be shut down, and its largest bank will be restructured. Depositors with more than €100,000 ($130,000) in either bank will face losses in the vicinity of 40 percent. In a bid to prevent a run on the island’s other banks and to stop money from fleeing the country, capital controls have been imposed -- guaranteeing that there will still be capital flight once the restrictions are lifted.

The effect on the Cypriot economy will be catastrophic. Businesses serving the banking sector will begin to fail immediately, and others will follow. Property values will plummet and unemployment will soar as the country is plunged into recession.

We’ve been here before of course, with Greece (twice), Spain, Portugal, and Ireland. And compared to those crises, the Cyprus installment of the eurozone drama has been brief, and the amounts of money involved relatively small. But while Cyprus should not, on the face of it, pose much of a threat to the euro project -- it accounts for less than one third of one percent of the eurozone economy -- the manner in which the crisis has been handled may make this the most damaging episode yet in the single currency’s turbulent history.

In past bailouts, the inevitable “haircut” was imposed mostly on bank bondholders, but because most of the assets of Cypriot banks are in the form of deposits, it was decided that depositors would have to take a substantial hit. An initial bailout proposal caused uproar last week when it emerged that insured depositors would face losses; under EU law, bank deposits up to €100,000 are guaranteed, but because that guarantee only applies in the event of a bank failure and the banks had not at that point failed, the savings were considered fair game.

That deal was rejected by the Cypriot parliament, and while the savings of insured depositors will not be raided under the terms of the new agreement, an alarming precedent has been set with the imposition of a levy on uninsured deposits. Eurozone leaders have let it be known that from now on they will target the savings of private individuals rather than inflicting losses solely on institutional bondholders such as other banks and pension funds.

Investors in Greece, Spain, and elsewhere have been thinking that if the eurozone can do this to savers in Cyprus, they can do it to them when their country needs another bailout (“when” is more likely than “if”). And that fear was brewing even before the chairman of the eurozone declared that the Cyprus deal would indeed be a "template" for future bailouts. As the euro and European markets fell, officials frantically attempted to row back from his statement amid fears of bank runs across southern Europe.