The bailout package for Cyprus, concluded on Monday after hectic parleys among 17 eurozone members, may not address the underlying malaise but aims to provide a reprieve to the beleaguered country and enable its continued participation in the monetary union. The deal scraps an earlier, highly controversial proposal to tax domestic deposits indiscriminately. The Cypriot parliament had rejected that proposal, which sparked off universal outrage. However, large depositors — with accounts having balances of €100,000 or more — will be taxed, and, along with bondholders, must bear losses whose quantum is yet to be determined. Banks in Cyprus which have remained shut during the crisis will be restructured with a few reckless ones weeded out. The most significant outcome hoped for would be the restoration of the ordinary citizen’s faith in the country’s financial system. Most Cypriots have retreated into a pre-modern economy dominated by cash. Cyprus is expected to receive the first instalment of the bailout, amounting to €10 billion or $13 billion by early May. Only the finer details of the package will support or reject the official claim that it is more equitable than any previous proposal, with the heaviest losses accruing to the largest banks. Cyprus will still undergo pain, but it will be of a different magnitude from the hurt that would have been caused by an indiscriminate tax on deposits, or for that matter, the pain flowing from the forced austerity packages in Greece and Spain.
Cyprus may have a pint-sized economy but the problems afflicting its oversized financial sector are grave enough to threaten not only the eurozone but, by some measures, the global financial system as well. This is because the rapidly failing Cypriot financial sector can easily set off a wider contagion, for example by way of bank runs, even in the more prosperous parts of Europe. Globalisation has raised the level of interconnectedness among banks to such a level that it has become extremely challenging for even countries such as India to shield themselves from an infection, no matter where it originates. Cyprus is not alone in letting its financial sector grow ahead of its needs: its banking system is some five to six times larger than what its economy would require. Cyprus’s problems are more complex also because it has been a tax haven, attracting large funds from Russia and other countries of the former Soviet Union. Even if Cyprus gets back on its feet, the world should learn its lesson from this globalised version of Gresham’s law: Bad money from a handful of wealthy tax scofflaws can and will drive out the good money of everyone else.