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Satyajit Das: 6 Ways the Cyprus Solution Will Exacerbate the European Debt Crisis

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Irrespective of the fate of Cyprus, the way the problem was solved has set a dangerous precedent.

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Financial markets have taken Cyprus in their stride. But it is important not to underestimate the potential fallout.The impact of relatively small events is unpredictable. The 1931 collapse of the small Austrian bank Creditanstalt precipitated a major financial panic. One the smallest countries in Europe with little over 1 million people and about 0.5% of the European Union (EU) economically, Cyprus, may prove a key inflection point in the crisis.

The well anticipated EU bailout package included the controversial provision that ordinary depositors pay a "tax" or "solidarity levy" on Cypriot bank deposits, amounting to a permanent write down in the nominal value of their deposits. The deposit levy was 6.75% on deposits of less than Euro 100,000 (the ceiling for European Union account insurance) and 9.9% for deposits above that amount.

The unprecedented write down of bank deposits was designed to raise around Euro 5.8 billion to reduce the size of the required bailout package to Euro 10 billion, consistent with the requirements of the International Monetary Fund (IMF) and eurozone members like Germany. It was also designed to avoid losses to the European Central Bank (ECB) which has major exposures to Cypriot banks via its Emergency Lending Assistance (ELA) Program, estimated at as much as Euro 10 billion.

Commentator Karl Whelan's memorably described the EU proposal to allocate part of the burden to depositors as "a stupid idea whose time had come".

Initially, the parliament in Cyprus failed to pass the necessary enabling legislation.

Cyprus explored alternative strategies including confiscation of pensions, additional taxes, and other sources of funding. Unsuccessful discussions were held with Russia for a financing package to secure Cyprus' position and protect the interests of the Russian state, its citizens, and banks who have substantial exposures.

With no other source of funding available and the ECB threatening withdrawal of emergency funding, Cyprus faced default and rapid economic collapse.

Under duress, Cyprus and agreed an amended plan on March 25, 2013. Whilst maintaining most of the original elements, the plan appears to amend the deposit levy.

"Small" depositors (below Euro 100,000) will be protected, being exempted from the levy.

A major restructuring of the two largest banks will take place. The troubled Laiki Bank will be divided into a good bank (including small depositors and emergency ECB funding) to be absorbed into the Bank of Cyprus and a bad bank which will be liquidated over time. Shareholders, bondholders, and ultimately larger depositors in Laiki Bank will have to absorb losses, the size of which is uncertain. There are some suggestions that losses may be capped at 40%. Shareholders, bondholders, and large depositors in Bank of Cyprus will then be written down so that the bank achieves a capital ratio of 9%.

Other measures include "temporary, proportionate and non-discriminatory" capital controls to prevent funds being taken out of Cyprus. There will also be a reduction in the size of Cyprus' financial sector to the EU average by 2018.

Two aspects of the agreed package are noteworthy. The bailout package (Euro 10 billion) cannot be used to re-capitalize banks, which limits its utility.

The plan does not need Cypriot parliamentary approval as it is no longer a "tax." The transfer of losses on large depositors takes place under recently adopted bank restructuring laws passed at Brussels' insistence.

The measures stave off the risk of immediate collapse and Cyprus having to leave the Euro. But the plan does not address Cyprus' problem.

As in Greece and Portugal, privatization proceeds and the revenue from increased taxes may not reach targets.
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