What precedent does this decision set for depositors in other EA countries? Do you believe official assurances that Cyprus is a unique case will be comforting and that the trust and faith of depositors in other peripheral nations will be completely preserved?
-Fred Copper, senior portfolio manager, international equity
Early Saturday morning, after 10 hours of negotiations, it was announced that Euro Area (EA) finance ministers had agreed upon a bailout package for the government and banking system of Cyprus. The total financing needs of Cyprus are 17 billion euros ($22 billion), which equates to approximately 100% of Cypriot gross domestic product (GDP), making this by far the largest bailout relative to the size of the economy yet in the EA. Despite the large relative magnitude however, the absolute size of the bailout is actually quite small. Cyprus represents less than one half of one percent of EA GDP, so even though the bailout equals the entire size of the Cypriot economy, it is rounding error in the scale of the EA overall. Why then was it necessary for the finance ministers from all over the EA to work through the night to hammer out a deal? Why not just give them the money in the interest of reinforcing the unity of the EA and move on to the next critical item on the list? Fairness and avoiding bad incentives are clearly important motivations, but precedent is the key factor. Whatever rules are established for one country will be assumed to apply to all, and while Cyprus is relatively small, Spain and Italy, who also have onerous debt burdens, are very large, and therefore a simple blank check approach to making their problems go away is out of the question. The next logical choice was to just loan them the money in exchange for some type of promise to pay it all back like they’ve done many times before, but the resulting debt burden would have been overwhelming, and as the experience of Greece has taught, unpayable debts not surprisingly end up not being paid, so a new solution was required.
