Source: National Interest

Cyprus is now receding from the headlines. But the recent financial crisis in the Mediterranean will long be remembered—both for the extraordinarily inept attempt to raid the small island nation’s insured deposits and the backtracking and finger-pointing that followed it.

The decision to “tax” insured deposits was taken during a weekend late night negotiation between Nicos Anastasiades, the country’s newly elected president, and the Troika (EU Commission, European Central Bank, and International Monetary Fund). It represented a blatant violation of the spirit, if not the letter, of a 2009 EU directive that all bank deposits below one hundred thousand euros should carry an insurance guarantee. As the saying goes, “trust, once broken, is forever lost” so the damage persists even if the proposal was stopped in its tracks by the Cypriot Parliament—a fortunate development for the eurozone’s stability.

The revised deal that was hammered out in another cliffhanger late-night negotiation is less dangerous but still carries grave consequences for Cyprus: by inflicting massive losses on uninsured depositors (those over one hundred thousand euros) and wiping out senior and subordinated bond holders, it effectively destroys the offshore-banking industry, which is the mainstay of the small island’s economy. It also makes a travesty of the claim that the government debt of Cyprus has been placed on a sustainable path, a major condition for the IMF’s participation in the rescue package. And it will, to a degree that is very difficult to assess, deter potential investors in banks across the eurozone periphery.

But despite the botched rescue attempt, and the dire prospects for the Cypriot economy, the recent chain of events ironically may bolster the eurozone.

Cyprus has shown that there is no obvious limit to the level of pain that a country will accept rather than face the chaos and disruption that would follow if it abandoned the euro. The conditions placed on Cyprus were extremely harsh and unprecedented, effectively closing down its most important industry—even though variations on the offshore-banking-sector model operate in other eurozone countries (including Luxembourg, Malta and Slovenia, whose banking sectors are proportionally as large or larger than that of Cyprus). It would have been like insisting that as part of its rescue program, Greece should close down its tourism and shipping industries all at once.

Yet at no point did the authorities in Cyprus seriously consider exiting the eurozone, adopting a devalued currency and defaulting on their government debt, measures that would undoubtedly help the small island economy adapt more rapidly to the enormous shocks it has suffered. To the contrary, while bitterly resentful of the program forced on them, the finance minister and president have explicitly rejected a Euro exit “as gambling with the country’s future.”

In step with Cyprus’ commitment, Germany and the rest of the Euro group have shown that they will go to extraordinary lengths to maintain the integrity of the monetary union. They will do so even when the country in question is tiny, amounting to a fraction of 1 percent of the block’s GDP. The rescue package for Cyprus, though insufficient to protect its banks, nevertheless amounts to 60 percent of its GDP—an extraordinary level that is proportionally larger than the bailout for Ireland or Portugal and about the size of Greece’s first package. The much agonized-over IMF rescue package for Egypt amounted to 2 percent of that country’s GDP. Moreover, the Troika loans to Cyprus supplement liquidity provisions made to Cypriot banks from the ECB (through the Central Bank of Cyprus) that may have been almost as large.

In other words, total support for Cyprus may exceed its GDP. On top of that, by allowing a massive raid on uninsured depositors, the eurozone countries showed that they were willing to risk a major diplomatic showdown with Russia, whose nationals are the main holders of such deposits.

The raid on uninsured depositors would not have been possible without the active support of the ECB, whose mandate has been recently expanded to include regulation of the zone’s most systemically important banks. The ECB’s ultimatum on Cyprus—it would withdraw liquidity support to its banks if the Troika’s program was not accepted—demonstrated to the periphery countries that, should the need arise for them to ask for help, including purchases by the ECB of their government bonds, it would come with very tough conditions. This mitigates the risk of moral hazard—the possibility that countries in the periphery will slacken their reform efforts along with a political backlash in Germany and other core countries—that would deter the ECB from carrying out its function as lender of last resort.

The ECB also allowed the Troika program to break the taboo against having senior bondholders bear losses before the taxpayer does. While this carries the risk of further accentuating the credit crunch (especially in the periphery countries), it also reduces moral hazard among those inclined to lend to the eurozone banking sector. Further, by providing more flexibility to “bail-in” creditors and depositors in the event of a bank rescue, it reduces the cost of future rescues and the likelihood of political backlash in the core countries. The net effect is probably to reassure holders of the periphery’s sovereign debt.

Through the pressure put on Cyprus and the willingness it showed to have large depositors and bondholders to shoulder losses, the Troika demonstrated that it is more confident of its ability to manage systemic risk—such as a contagious deterioration of confidence in the zone’s banks. This approach is a result not only of political necessity and budget constraints, but also of a conviction that the market environment has become more benign.

Last and not least, the fact that the market reaction to the messy and alarming events in Cyprus was remarkably muted, especially considering that they coincided with an ongoing and profound political crisis in Italy, is significant. The Euro is weaker, which is a good thing, but stock markets have seen only modest declines and the spreads on periphery-government bonds have widened a little. This resilience stands in stark contrast with previous episodes, notably the worst days of the crisis in Greece, Italy and Spain.

In addition to the belief that the ECB will step in as needed, markets have been reassured by a number of indicators suggesting that the combination of fiscal and competitive adjustment in the periphery is slowly making progress. Unit labor costs have already declined sharply in Ireland and Portugal and significantly in Spain and Greece. Worryingly, Italy has made little progress on competitiveness, but its government runs a large primary surplus (it is in surplus net of interest payments) and its budget is already close to balance when account is taken of its deep recession. Exports of the periphery countries are growing at a fair clip, and the building recovery in the United States and rapidly growing emerging markets reinforce the view that the conditions for growth are slowly returning.

It is possible to read too much into these developments. It is unlikely, for example, that the Troika could place anywhere near as tough conditions on Italy or Spain as on Cyprus, if for no other reason than the systemic risks implied would be much greater, giving the large countries bigger leverage in negotiations. And, in any event, the amounts of money needed to support a large periphery country may prove to be politically unacceptable in the core countries. But there is no question that Cyprus has set new precedents, and that these could significantly increases the Troika’s room for maneuver in future rescues.

Has the crisis in the eurozone passed its most acute phase? Will things become easier from now on? Only the future will tell. Despite the horrendous decision-making process, the events in Cyprus offer reassuring signs about the future of the Euro. But the zone remains very exposed to any number of external or internal shocks and bouts of uncertainty that could again test its policymakers. The threats to the viability of the single currency have not disappeared. And, even in the best of circumstances, at least another year of recession and perhaps two awaits most countries in the periphery—meaning that their political cohesion will continue to be severely tested.

One thing is certain. The events in Cyprus do not provide grounds to change the widely prescribed remedies for eurozone banks, and they only reinforce them: all countries, and especially those with large banking sectors, must tighten regulation and insist on higher capital requirements where they are needed. The eurozone must accelerate the building of the infrastructure necessary to operate an integrated banking system as part of the monetary union. That will require going beyond a common supervision authority housed in the ECB to include a shared deposit-insurance scheme and common bank-resolution mechanism. Such steps, if taken earlier, would have largely avoided the mess in Cyprus.

This article was originally published in the National Interest.